CBl-13: Interpreting accounts (1)
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Interpreting accounts {l)
Syllabus objectives
4.2
Interpreting company accounting information:
1.
Priority percentages and gearing.
2.
Interest cover and asset cover for loan capital.
3.
The impact of interest rate movements on a highly geared company.
4.
The price earnings ratio, dividend yield, dividend cover and EBITDA.
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CBl-13: Interpreting account s (1)
Introduction
Analysis of company accounts is useful to appraise companies for investment purposes and to
understand how well they are being managed. Across these next two chapters we introduce
many of the tools needed to analyse accounts for these purposes and define the key accounting
ratios.
Accounting ratios are a useful way to make comparisons between companies. In particular, by
using a ratio rather than a single number, it is possible to make comparisons which are not
distorted by the size of the companies.
Ratios are practical tools used by investment analysts, eg when deciding which share to purchase.
Consequently, there is often no 'right' definition of a particular ratio. Indeed, often there is no
' right' ratio to look at in a particular case.
In this chapter, we start by focusing on loan capital. In particular, we look at measures to assess
the security of loan capital. We then turn our attention to measures involving share information.
To illustrate ratio calculations, throughout the next two chapters we will use the accounts set out
below for Cover-up Limited, a supplier of specialist equipment and technical advice. From time to
time we will refer back to the next two pages (this information is repeated at the start of the next
chapter for ease of reference).
The examination may test the ability to calculate various accounting ratios but just as importantly,
it may test interpretation of the ratios.
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Statement of profit or loss for Cover-up Ltd for the year 20XO
£000s
Revenue
250,000
Cost of sales:
Cost of stock used:
Raw materials purchased
95,000
Decrease in stocks of finished goods and work-in-progress
7,000
102,000
Depreciation
30,000
(132,000)
Gross profit
118, 000
Administrative expenses and other overheads
(85,000)
Operating profit
33,000
Finance income
2,000
Profit before interest and taxation
35,000
Finance costs
(9,950)
Profit before taxation
25,050
Tax
(8,267)
Profit for the year =
Profit for the year attributable to equity holders of the company
EPS for profit attributable to equity holders
16,783
10.Sp
Note to the accounts:
The company proposes to make a dividend payment of £6,000,000, ie 3.75p per ordinary share, in
respect of the year ending 31 December 20X0.
CBl-13: Interpreting accounts (1)
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Statement of financial position for Cover-up Ltd as at 31 December 20XO
£000
ASSETS
Non-current assets
Intangible assets
20,000
Tangible assets
75,000
95,000
Current assets
Inventories
42,000
Trade receivables
60,000
Cash
14,000
116,000
Total assets
211,000
EQUITY AND LIABILITIES
Called up share capital (160 million shares @ 25p)
40,000
Retained earnings
20,000
Other reserves
10,000
Total equity
70,000
Non-current liabilities
10% unsecured loan stock 20X7
25,000
11% subordinated loan stock 20X4
19,000
9¾% mortgage debenture 20XS
16,000
9½% Eurosterling 20X4
40,000
Total non-current liabilities
100,000
Current liabilities
Trade payables
32,000
Taxation
9,000
Total current liabilities
41,000
Total liabilities
141,000
Total equity and liabilities
211,000
CBl-13: Interpreting accounts (1)
1
Pages
Measuring risk associated with loan capital
In general, if a company has a high level of operating profit in relation to the annual interest due on
its loan capital, the loan interest should be secure. The higher the ratio of profits to interest
payments, the more scope there is for profits to deteriorate before a company will default on its
loan capital interest payments.
We can also consider what happens if the company does default on its interest payments. Whether
the loan stock holders get any money back depends on whether the available assets of the company
are sufficient to meet the claims of the loan capital holders.
To assess this, investors in loan capital can look at the ratio of the available assets to the amount of
the loan stock. A high ratio gives scope for future reductions in the value of the company's available
assets without endangering the asset security for the loan capital.
So assets and income are important in this context. The two main ratios associated with loan capital
are called the interest cover and the asset cover.
Shareholders will normally regard loan capital as a mixed blessing. It is a cheap source of
finance for the company because it normally carries a relatively low risk for the lender.
Question
Explain the remark 'loan capital normally carries a relatively low risk for the lender'.
Solution
Consider the different possible risks to the investor (ie the lender):
•
Default risk - Loan stock capital ranks higher in the event of a wind - up than equity and
preference shares, so can be described as relatively low risk.
•
Market risk - Because the income flow is fixed and the security is better than equities, it is
generally the case that the market price of debt securities is more stable than that of
equity capital. Therefore the market risk is relatively low.
This means that the shareholders will normally expect to enjoy a higher rate of return from
their investment in share capital if the company is partly financed by borrowing.
The alternative would be that addltlonal finance would have been raised by the sale of
additional shares, thereby diluting the returns enjoyed by the orlglnal shareholders.
There Is, however, a downside to this. The security enjoyed by the lenders has the effect of
increasing the risk attributable to the shareholders.
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Th is Is because:
•
the interest has to be paid regardless of whether the company is making profits
•
the greater the proportion of the company's assets that are financed by debt, the
greater the risk that there will be nothing left for the shareholders if the company
falls.
There are a number of ratios which can be used to measure the risks borne by the
shareholders because of the company"s borrowing policy. These should not be confused
with the risks which arise because of any volatlllty In the underlying business Itself.
1.1
Interest cover
Interest cover on an issue of loan capital is defined to be profit on ordinary activities before
interest and taxation divided by the annual interest payments due on that issue of the loan
capital and on all prior ranking loan capital.
profit on ordinary activities before interest and taxation
Interest c o v e r = - - - - - - - - - - - - - - - - - - - - - - - - annual interest payments due on that issue of loan stock+ all prior loan stock
Put simply, it measures the number of times that the company could pay its interest out of
profit before tax and interest. The higher this multiple, the less likely that the company will
run into difficulty.
Interest cover is sometimes known as income cover. To calculate the interest cover on the
different types of loan capital issued by Cover-up Ltd, we need first to split up the ' interest payable
on long-term debt'.
The interest payable on an issue of debt can be calculated from the nominal amount
outstanding and the interest rate shown in the financial statements.
Below we set out the split of interest in order of priority. The mortgage debenture (highest ranking)
comes first. The unsecured loan stock and Eurosterling will probably rank equally. The
subordinated loan stock will rank lowest.
Calculation of interest cover for Cover-up Ltd
Interest on 9¾% mortgage debenture
1,560 (0.0975 X 16,000)
Interest on 10% unsecured loan stock
2,500 (0.10 X 25,000)
Interest on 9½% Eurosterling
3,800 (0.095 X 40,000)
Interest on 11% subordinated loan stock
2,090 (0.11 X 19,QQQ)
9,950
35,000
Interest cover on mortgage debenture
=
Interest cover on unsecured loan stock
35,000
= -------(1, 560 + 2, 500 + 3,800)
1,560
=22.4x
=4.Sx
CBl-13: Interpreting accounts (1)
Interest cover on Eurosterling
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35,000
=-------(1,560 + 2,500 + 3,800)
=4.Sx
Question
Calculate the interest cover for the subordinated loan stock.
Solution
Interest cover= _ _ _ _3_5_
,o_oo
_____ 3.5 x
1,560 + 2,500 + 3,800 + 2,090
It Is normally considered risky If the company cannot cover Interest at least three or four
times.
This Is, however, a general principle. If, for example, the company has a stable, predictable
stream of profits then it could afford to operate with a lower interest cover.
In addition, there is normally a trade- off between lower security and a higher expected return.
The main limitations of interest cover are that it does not consider how volatile profits are, nor
does it take account of the length of time for which the loan is outstanding. For example consider
the likelihood of default on the following two loan stocks:
1.
a 25-year loan stock issued by a company with profits that fluctuate greatly from year to
year with an interest cover of 5x.
2.
a 5-year loan stock issued by a food retailer (stable profits) with an interest cover of 2x.
It is likely that the second is much safer than the first, despite the lower interest cover figure.
To take account of this, an investor is likely to modify the 3x or 4 x rule of thumb depending upon
the stability of profits and the term of the loan stock being analysed.
It is also sensible to calculate the average interest cover from the last few years' accounts, rather
than rely only on the latest set of accounts. This will enable the analyst to make some allowance for
the volatility of profits.
As default by the company on any of its loan stock may result in the company winding up, this may
be bad news for all of the other loan stock holders (particularly if the company's assets are
insufficient to repay all of the loan capital).
So it is common practice to calculate interest cover on all the company's issues of loan capital, not
just the particular issue that an investor is considering purchasing.
1.2
Interest priority percentages
Interest priority percentages show the slice of profit on ordinary activities before interest
and tax which covers the annual Interest payments due on each Issue of loan capltal.
CBl-13: Interpreting accounts {1)
Pages
If the interest cover for the loan stock in question is x and the interest cover for the loan stock
immediately prior in ranking to the one in question is y, then the interest priority percentage for the
1
1
loan stock is - to - .
y
X
For each Issue of loan capital there will be a lower and upper Interest priority percentile.
The lower percentile Is calculated as the Inverse of the cover figure for the previous highestranking issue. The upper percentile is calculated as the inverse of the cover figure for the
issue of loan stock being considered.
This may seem complex, but it will become clear with the help of an example.
This statistic Is more relevant to lenders.
If the company has, say, given some lenders a fixed charge or a mortgage over specific
assets then these loans will be repaid before loans with floating charges. Unsecured loans
will be repaid after these.
This ranking will be relevant to a lender who has to decide whether the other loans that the
company has taken out will affect the risk of a further investment.
Calculation of interest priority percentages for Cover-up Ltd
Interest cover
Interest priority
(see above)
percentages
Mortgage debenture
22 .44x
0% to 4.5%
Unsecured loan stock
4.4Sx
4.5% to 22.5%
Eurosterling
4.4Sx
4.5% to 22.5%
Issue of loan capital
liJ
Question
Calculate the interest priority percentages for the subordinated loan stock.
Solution
The interest cover figure for the unsecured loan stock and Eurosterling issues is 4.45x.
The interest cover figure for the subordinated loan stock is 3.52x.
The interest priority percentages for the subordinated loan stock are therefore:
1
1
- - to - - , ie 22.5% to 28.4%
4.45
3.52
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We can interpret the priority percentages in the above example as follows: Given a figure of £35,000
available to pay the interest on the loan capital:
•
the first 4.5% of this amount is needed to meet the interest on the highest ranking loan
capital (the mortgage debenture)
•
the next 18% (of the £35,000) is needed to pay the interest on the next highest ranking
loan capital (the unsecured loan stock and the Eurosterling)
•
the next 6% is needed to pay the interest on the lowest ranking loan capital (the
subordinated loan stock).
1.3
Asset cover
Asset cover on an Issue of loan capital Is usually defined to be:
total assets less current liabilities less Intangible assets
loan capital plus prior ranking debt
This amount will usually represent a conservative estimate of the amount of money
available to meet the loan stockholders' demands for repayment if the company were to
wind up.
The assumption is that assets other than intangibles will be converted into cash at their
book values, while intangible items are likely to be worthless on winding up. This is, of
course, dependent on the nature of the business and its assets. A valuable brand name or
patent might well be worth more than all of the company's other assets put together.
Current liabilities are assumed to be repaid before the debtholders even though they may
rank below the loan capital.
It is standard practice to regard a class of loan which has an asset cover less than two or
two and a half times as high risk.
An alternative definition of asset cover which is often used in practice is:
total assets less current liabilities less Intangible assets
total loan capital
However, we will be using the first definition in the following examples.
For Cover-up Ltd, total assets less current liabilities less intangible assets equals £150,000
(ie 211,000- 41,000- 20,000).
The idea is that the assets could be converted into cash at the balance sheet value. However,
intangible items (eg goodwill) are likely to be worthless on winding up, so they are excluded.
Current liabilities are assumed to be repaid before the stockholders even though they may rank
below the loan capital. The reason for this is that companies getting into trouble may find it
difficult to get credit from their suppliers and might have very low current liabilities anyway by
the time the company is wound up.
CBl-13: Interpreting accounts (1)
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Calculation of asset cover figures for Cover-up Ltd
Iii}
150,CXX)
Asset cover on mortgage debenture
= 16, CXX) =9.4 x
Asset cover on unsecured loan stock
=
150,000
=19 x
(16,000+25,000+40,000)
Asset cover on Eurosterling
=
150,000
=19 x
(16,000+25,000+40,000)
Question
Calculate the asset cover for Cover-up' s subordinated loan stock.
Solution
150,000
16,000 + 25,000 + 40,000 + 19,000
Asset cover= - - - - - - - - - - - - - - = 1.S x
The main limitation of asset cover is that the current value shown in the statements of
financial position for assets might not reflect their realisable market value if the company is
wound up. The going concern concept means that there is no particular need to carry
assets at their market values.
The minimum of 2x cover gives a safety margin, but an arbitrary one. Also, like interest cover,
capital cover does not take account of the term of the loan stock.
An investor is likely to modify the 2x rule of thumb depending upon the likely realisable value of the
assets, the term of the loan stock being analysed and the adequacy of the interest cover.
1.4
Asset priority percentages
Asset priority percentages show the slice of total assets less current liabilities less
Intangible assets which Is available to cover the nominal value of each Issue of loan capita I.
For each Issue of loan capital there wlll be a lower and upper percentile.
The lower percentile is calculated as the inverse of the cover figure for the previous highestranking Issue.
The upper percentile Is calculated as the Inverse of the cover figure for the Issue of loan
stock being considered.
Iii}
Question
Cal culate th e asset priority percentages for Cover-up's subordinated loan stock and inte rpr et th e
figures.
CBl-13: Interpreting accounts (1)
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Solution
The asset cover for the unsecured loan stock and Eurosterling issues is 1.85x.
The asset cover for the subordinated loan stock is 1.S0x.
The asset priority percentages for the subordinated loan stock are therefore:
-
1
1.85
to -
1
1.5
, ie 54.0% to 66.7%
This means that, if the company were wound up, the first 54% of the company's assets would go
towards covering the company's liabilities to the holders of the mortgage debenture, unsecured
loan stock and Eurosterling issue. The next 12.7% of the company's assets would go to the holders
of the subordinated loan stock.
1.5
Gearing
Gearing refers to the relative proportions of long-term debt and equity finance in a
company. High gearing means that the company has a high level of debt financing.
In the US, gearing is known as 'leverage'.
There are many different ways of defining gearing. The common feature is that high gearing means
that the company has a high ratio of debt finance (eg loan capital) to equity finance (ie share capital
and reserves).
Gearing can be measured using the statement of financial position figures for debt and equity.
Asset gearing
Asset gearing is also known as 'capital gearing'.
There are two commonly used definitions of asset gearing, either:
borrowings
equity
or
borrowings
borrowings + equity
The term 'borrowings' will usually Include all forms of long-term loan capital.
The term 'equity' In this definition means the book value of the ordinary shares ie 'capital
and reserves'. It Is normal to deduct the amount of any intangible assets.
By doing this, we are effectively 'writing off intangible assets against reserves, which is what a lot of
firms do anyway. This is sensible since we need to be consistent between companies, only some of
which choose to show intangible assets in their statement of financial position.
Where the data is available, and depending on the purpose of the calculation, some analysts like to
use market values of loan stock and share capital instead of the balance sheet values.
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The treatment of preference shares varies. Usually they are included as part of borrowings
rather than as part of equity because they carry a fixed rate of dividend and because their
holders are repaid before ordinary shareholders In the event of default.
This is appropriate when analysing gearing from the perspective of ordinary shareholders.
This means that they are more like liabilities when viewed from the perspective of the
ordinary shareholders. The treatment of preference shares within related ratios, such as
interest cover, needs to be consistent
A company whose gearing reached 40% using the second of the above formulae would
normally be regarded as high risk.
Using the first definition given above (ie borrowings to equity), asset gearing for Cover-up is
calculated as:
25,000+19,000+16,000+40,000 = 100,000
40,000+20,000+10,000-20,000 50,000
200"/o
Ui11 Question
Calculate asset gearing for Cover-up using the second definition of gearing (ie debt to total
capital).
Solution
Asset gearing = -
100,000
- - - -- =66. 7%
100,000 + 50,000
So Cover-up is pretty highly geared by most measures.
The reasons for gearing increasing risk can be illustrated with the following example
involving two identical companies, one financed by 4 million ordinary shares of £1, the
other by 2m shares and £2m of 12% loan stock:
Average year
Lowg_ear
Hig_hg_ear
540,000
540,000
0
(240,000)
Eamlngs before tax
540,000
300,000
Tax(30%)
(162,000)
(90,000)
378,000
210,000
4m
2m
9.45p
10.Sp
Eamings before interest and tax
Interest
No of shares
Eamings per share (pence)
CBl- 13: Interpreting accounts (1)
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Thus, the shareholders benefit from gearing In an average year because the Interest rates
are relatively low and because the company enjoys the benefit of tax rellef on the loan
Interest.
The 12% interest on debt may not be low in absolute term s but is low relative to the return
enjoyed by the equity shareholders who contributed £4 million capital of
540 000
'
4,000,000
= 13.5%.
We now consider the effect if the profits double:
Goodyear
Lowgear
Highgear
1,080,000
1,080,000
0
(240,000)
Earnings before tax
1,080,000
840,000
Tax(30%)
(324,000)
(252,000)
756,000
588,000
4m
2m
Earnings per share (pence)
18.9p
29.4p
Times average year's EPS
2.0 x
2.8 X
Earnings before interest and tax
Interest
No of shares
In a good year, earnings before interest and tax have doubled.
This results in a doubling of the returns to shareholders in the low-geared company.
The high-geared company has, however, had its shareholders' return increase 2.8 times.
This Is because of the effects of the fixed payment of Interest on the half of the long-term
finance which comes from borrowing.
However, if profits halve...
Bad year
Lowgear
Highgear
270,000
270,000
0
(240,000)
Earnings before tax
270,000
30,000
Tax(30%)
(81,000)
(9,000)
189,000
21,000
4m
2m
Earnings per share (pence)
4.725p
1.05p
Times average year's EPS
0.S x
0.1 X
Earnings before interest and tax
Interest
No of shares
The gearing effect Is even more pronounced when the company has a poor year.
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In this case, halving the earnings before Interest and taxation halved the shareholders'
return In the ungeared company.
The highly geared company's return was reduced to one tenth that of a normal year.
The gearing ratio Is Important because Increasing the proportion of debt In the company's
long-term finance tends to accentuate any volatility In the underlying business. This would
tend to increase the total risk for shareholders.
In extreme cases, where it might force the company to risk default, it might also create
some risk for lenders.
An associated ratio used by financial analysts is the shareholders· equity ratio
shareholders' equity - intangibles
total assets - current liabilities - Intangibles
This is similar to the second definition of asset gearing, but this ratio looks at the proportion of
finance provided by equity, rather than the proportion provided by debt.
The higher this ratio, the stronger the financial position of the organisation. The lower the
proportion, the more possibility of the organisation becoming over-dependent on outside
providers of capital.
The term shareholders' equity in this definition means the statement of financial position value of
the capital and reserves. It is normal to deduct the amount of any intangible assets.
lmJ Question
Calculate the shareholders' equity ratio for Cover-up.
Solution
70,000-20,000
Shareholders' equity ratio= - - - - - - = 33.3%
170,000-20,000
Income gearing
The most commonly used definition of income gearing is:
interest on borrowings
profit on ordinary activities before interest and tax
'Interest on borrowings' will usually Include all forms of Interest payable on debt.
This includes interest on loan capital, and on overdrafts.
The treatment of preference shares again varies. When they are Included as part of 'Interest
on debt', they should be grossed up at the company's rate of corporation tax.
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So the definition would be:
.
b
.
preference dividends
interest on orrowmgs + - - - - - - - - (1 - corporation tax rate)
profit on ordinary activities before interest and tax
Dividends are grossed up at the corporation tax rate because preference share dividends are paid
out of after-tax profits and we are assessing how much interest cost the company is bearing.
The true cost to the company of £x of preference dividends at the before tax level is £x/(1 - t)
(assuming a corporation tax rate oft).
Uiil Question
Calculate income gearing for Cover-up Ltd.
Solution
Income gearing =
9 9
, so
35,000
=28.4%
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2
Ratios involving share information
Investors in ordinary shares are entitled to receive dividends, which may be very large
relative to the issue price of the shares if the company is successful. Equally, the dividends
may not be paid at all if the company is unsuccessful.
Whilst ordinary shareholders may look at the cover and gearing ratios we have covered so far,
income and capital cover will not be their main concern.
They will want to know about a company's profitability, efficiency, earnings for ordinary
shareholders and dividends.
2.1
Earnings per share
In principle, earnings per share is a simple concept:
.
h
earnings on ordinary activities
earnings per s are = - - - - - - - - - - - -
number of issued ordinary shares
Within this context, earnings on ordinary activities are usually taken to mean earnings for
ordinary shareholders.
The earnings per share (EPS) ratio is the amount of profit that has been earned for each
ordinary share.
It is customary to calculate this ratio by taking the net profit after taxation and, since it is
concerned with the ordinary shareholders' position, it excludes any preference dividend.
In other words, the payments in respect of preference dividend are deducted from the earnings
before the calculation of the ratio.
Businesses whose shares are publicly traded are required to disclose two versions of
earnings per share.
Basic earnings per share
This is calculated by dividing the net profit or loss for the period attributable to ordinary
shareholders by the weighted average number of ordinary shares outstanding during the
period.
The net profit or loss attributable to ordinary shareholders is after taxation, minority
interests, extraordinary items and preference dividends.
'Minority interests' was described earlier as 'non-controlling interests'.
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Diluted earnings per share
The basic EPS takes Into account only those equity shares In Issue that were outstanding
during the period.
However, a company may have entered Into obligations that could dilute the EPS In the
future. In such cases, the basic EPS should be adjusted for the effects of all dilutive
potential ordinary shares.
The calculation should be made on the assumption that any conversion rights or options
had been exercised In full on the first day of the accounting period. {If the date of Issue of
the securities giving rise to the rights or options Is later, a weighted average calculatlon
should be performed.)
For example, consider a company which has earnings on ordinary activities of £75m for the year
ending 31 December.
During the year, there were 500m ordinary shares in issue. On 1 July, £50m of convertible loan
stock was issued, with the option to convert into ordinary shares in five years' time . Under the
conversion terms, if all of the loan-stock holders take the option to convert, 100m new ordinary
shares will be issued.
£75,000,000
The earnings per share for the year are - - - - - = lSp per share.
500,000,000
Since we had 500,000,000 shares for six months and a potential 600,000,000 for the second six
months, the weighted average number of shares allowing for conversion rights is:
0.5 X 500,000,000 + 0.5 X 600,QQ0,000 = 550,000,000
Therefore, the diluted earnings per share are
£75,000,000
- - - - - = 13.6p per share
550,000,000
There are various other ways of calculating EPS. For example, some companies provide
additional EPS figures that exclude exceptional Items or exclude discontinued operations.
It Is difficult to see why the EPS ratio should command so much attention . The number of
ordinary shares Is, after all, a meaningless number. A company wishing to raise £1m of
share capital could, for example, Issue 1m £1 shares, 2m 50 pence shares or 1Om 1Opence
shares.
It Is Important as It Is used as the basis for the calculatlon of the Price/ Earnings (P/E) ratio.
f
~ Question
t /1
A company' s pre-tax profits have doubled over the past four years but EPS have hardly grown at
all. Give two reasons why this might have occurred.
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Solution
Possible reasons would include:
2.2
•
acquisitions by the issue of shares
•
a higher tax charge than in earlier years.
Price earnings ratio
market price of an ordinary share
priceeamIngs ratio = - - - - - - - - - - earnings per share
The earnings per share figure used in this ratio can be historical or prospective.
Some analysts calculate a PE ratio based on their best estimate of the company's earnings over the
next 12 months. This is known as a prospective PE ratio. Other analysts calculate the PE ratio based
on the previous year's earnings. This is known as a historical PE ratio.
Where companies have convertible shares or share options that may at some point be converted
into new shares, it is common to calculate the PE ratio on a 'full conversion basis' using diluted
earnings per share.
The market price of the share encapsulates everything that the market knows about the
company. Relating this to earnings gives an insight into the market's opinion of the
company's performance.
If the price earnings ratio is high then that would suggest that the company is relatively
attractive when considered as a source of revenues. This might imply that the market
believes:
•
that the company Is a relatively low risk Investment, or
•
earnings will grow rapidly in the future.
If the P/E ratio of a share is high relative to other, similar companies (taking the above
factors into account) it may mean that the share is overvalued.
Use of the price earnings ratio
Earnings are the amount of money generated by the company for its shareholders. These are of
fundamental importance in determining the income a shareholder receives and also the potential
for growth of the company.
The price earnings ratio shows how many times bigger the price of a share is than the earnings
that the share produces.
There are two main reasons why investors might be prepared to pay a bigger multiple of the
earnings for one share than for another share:
1.
they expect earnings to grow rapidly, so are paying for expected high future earnings
2.
the earnings are considered to be less risky.
CBl-13: Interpreting accounts (1)
Pag e 19
To use this ratio sensibly, we could consider the likely growth prospects of the company, and so
derive the PE ratio that the share should have. The share is then expensive (cheap) if the actual PE
ratio is higher (lower) than the estimated PE ratio.
One way of estimating the PE ratio that a company should have is to consider what is normal for the
industry to which the company in question belongs. A company whose shares have a PE above the
norm for the industry may be considered expensive (or to have above average growth prospects).
In theory (and almost certainly In practice) the P/E ratio will vary as a result of changes In
the share price. Unfortunately, many directors behave as If the relationship has been
inverted. They seem to assume that the PIE ratio is fixed (or is at least 'sticky') and that the
share price can be improved by overstating the EPS.
2.3
Dividend yield
dividend yield =
dividends per share
market price of an ordinary share
Use of dividend yield
In theory, the value of a share is the discounted present value of the proceeds obtained from
owning it. If held forever, the present value of a share can be taken to be the discounted value of all
future dividends. Thus dividends are of key importance to shareholders.
The dividend yield measures the amount of current Income (dividends) an Investor receives
per unit of Investment (the share price). A low dividend yield may mean that:
1.
Investors expect dividends to grow rapidly, or
2.
the share Is overvalued.
The dividend yield cannot be Interpreted as the expected return on a share because It
shows only part of the return for an Investor - It Ignores any potential capital gain.
2.4
Dividend cover
dividend cover = earnings per share
dividends per share
This way of calculating cover is not directly comparable with the interest cover used for
loan capital.
f 1'I Question
.s.
L~
Explain why the calculations are not entirely consistent.
Solution
Interest cover and asset cover are calculated by dividing the total income (or assets) available by
the loan stock + all prior debt.
CBl-13: Interpreting accounts (1)
Page 20
To be consistent, when calculating dividend cover, we would have to calculate the total income
available to equity shareholders+ all prior ranking capital (debt, preference, ...) and divide by the
dividends on ordinary shares+ all prior capital. This is not what is done.
The inverse of the dividend cover is the payout ratio.
.
1
dividend per share
payoutrat10 = - - - - - = - - - - - - dividend cover earnings per share
Use of dividend cover
Dividends are paid out of earnings. In the long run, a company will not be able to maintain
dividends If they are not covered by earnings.
In contrast, a company with a high level of dividend cover has more scope to increase
dividends In the future.
So, for a given dividend yield on a share, a high dividend cover figure suggests better value
for money than a share with low dividend cover.
There is a relationship between the PE ratio, the dividend yield and dividend cover:
market price
dividend per share
dividend per share
earnings per share
market price
earnings per share
------- x -------=------ie
2.5
PE ratio
x
dividend yield
= payout ratio
EBITDA
The statement of profit or loss shows how operating profit reflects revenue less the cost of
sales, distribution costs, administrative expenses and other operating income.
The operating profit plus finance income is sometimes referred to as earnings before
Interest and taxation (EBIT).
The figure does, however, allow for depreciation and amortisation charges.
Some analysts feel that these are not well measured In statements of profit or loss, since
the amounts charged are based on subjective analysis and may therefore be seen as
discretionary. They prefer to focus on earnings before Interest, taxation, depreciation and
amortisation (EBITDA). This is often referred to as 'cashflow from operations'.
(The evaluation of depreciation charges was covered previously. Amortisation is a similar
exercise in respect of intangible assets such as goodwill, advertising and research and
development, R&D.)
EBITDA can be used to calculate an alternative version of earnings per share. This can th en be
used to compare different companies or to look at trends over time for a particular company if
tax, depreciation or amortisation might otherwise distort the comparison.
CBl-13: Interpreting accounts (1)
iJ
Page 21
Question
Calculate the following ratios for Cover-up Ltd, given that its current share price is 200p.
(i)
EPS
(ii)
EBITDA per share
(iii)
PE ratio
(iv)
dividend yield
(v)
dividend cover.
Assume that the dividend proposed is approved and paid.
Solution
(i)
EPS
=
(ii)
EBITDA per share
=
(iii)
PE ratio
=
=
iJ
(iv)
dividend yield
=
(v)
dividend cover:
=
16, 783 =10.49
160,000
p
35,000+30,000
160,000
40.63p
market price of an ordinary share
earnings per share
200
10.49
=19.1x
G,OOO x lOO x- 1- = 0.019 or 1.9%
200
160,000
earnings
dividends
16,783 = 2 .Sx
6,000
Question
A company made £Sm pre-tax profit last year. It paid a dividend for the year of £0.02 per share.
It has 100m shares in issue currently priced at £1.
Assuming corporation tax is charged at 20%, calculate:
(i)
earnings per share
(ii)
dividend cover
(iii)
dividend yield
(iv)
PE ratio.
Page 22
CBl-13: Interpreting accounts (1)
Solution
(i)
Post-tax profits is £Sm x (1- 0.2) = £4m. Divided between 100m shares, this gives earnings
per share of 4.0p.
4
(ii)
Dividend cover= -=2.00x
(iii)
Dividend yield = -
(iv)
The price earnings ratio is -
2
2
100
= 2%
100
4
= 25.0x
CBl-13: Interpreting accounts (1)
Page 23
Chapter 13 Summary
Ratios involving debt
profit on ordinary activities before interest and taxation
Interest cover = - - - - - - - - - - - - - - - - - - - - - - - - annual interest payments due on that issue of loan stock+ all prior loan stock
Interest priority percentages show the slice of profit on ordinary activities before interest
and tax which covers the annual interest payments due on each issue of loan capital.
total assets less current liabilities less intangible assets
Asset cover =
loan capital plus prior ranking debt
Asset priority percentages show the slice of total assets less current liabilities less intangible
assets which is available to cover the nominal value of each issue of loan capital.
borrowings
borrowings
equity
borrowings+ equity
Asset gearing= - - - - or - - - - - - ,
.
.
shareholders' equity - intangibles
SharehoIders eqwty ratio=----------'--'------'---total assets - current liabilities - intangibles
interest on borrowings
Income g e a r i n g = - - - - - - - - - - - - - - - - - profit on ordinary activities before interest and tax
Ratios involving share information
.
h
Earn1ngs per s are =
earnings on ordinary activities
number of issued ordinary shares
.
.
.
market price of an ordinary share
Pnee earnings ratio = - - - - - - - - - - - earnings per share
. .d d . Id
dividends per share
D1v1 en y1e = - - - - - - - - - - - market price of an ordinary share
. .d d
earnings per share
D1v1 en cover = - - - - - - dividends per share
.
Payout ratio
dividends per share
1
=- - - - - - =- - -earnings per share
dividend cover
Page 24
CBl-13: Interpreting accounts (1)
The practice questions start on the next page so that you can
keep the chapter summaries together.
CBl-13: Interpreting accounts (1)
Page 25
(J~ Chapter 13 Practice Questions
13.1
Exam style
Consider both Statement 1 and Statement 2 and decide, for each statement, whether it is true or
false.
If, and only if, you consider both statements to be true, you must decide whether Statement 2 is a
valid explanation as to why Statement 1 is true.
Statement 1 (Assertion)
A company's interest cover has no
Statement 2 (Reason)
The company may be able to pay
BECAUSE
interest on its loan stock even
real meaning for an investor in the
company's loan stocks.
when profit before interest and tax
is negative.
13.2
Exa style
A
B
1 true, 2 true, 2 is a valid explanation to support 1
1 true, 2 true, 2 is NOT a valid explanation to support 1
C
D
1 true, 2 false
1 false, 2 true
E
1 false, 2 false
The following figures are available from ABC Ltd's accounts. Unless stated otherwise the figures
are as at the end of the financial year:
£000
Sales
200
Inventories at the beginning of the year
30
Inventories at the end of the year
20
Purchases
130
Administrative expenses
15
Trade receivables
40
Prepayments
3
Cash
17
Bank overdraft
12
Trade payables
10
Accruals
2
ABC Ltd has issued 200,000 50p ordinary shares. During the year, it paid a dividend of 4.5p.
ABC Ltd's dividend cover (ignoring taxation) is:
A
2.5 times
B
3.1 times
C
5.0 times
D
6.7 times
CBl-13: Interpr eting accounts (1)
Page 26
13.3
Exam styt~
Which of the following would NOT explain why the PE ratio of a particular company may stand
above the average PE ratio of other companies?
A
B
the company's shares are overvalued
earnings are perceived to be relatively risky
C
historical earnings are unusually low
D
potential earnings growth is very high
CBl-13: Interpreting accounts (1)
Page 27
111 Chapter 13 Solutions
,.....,
13.1
Answer= D
Statement 2 is true. A company may be able to pay interest on a loan stock even when profit before
interest and tax is negative if it has the spare cash (or an overdraft facility) available.
However Statement 1 is false. The long-run success of a company depends upon it making profits.
It is therefore sensible to consider the company's profits (and hence interest cover) when assessing
whether or not to invest in the company' loan stock. If the losses persisted, the company might run
out of cash and default on the loan.
13.2
Answer = C
earnings per share
Dividend cover= ----"---'----dividend per share
profit after tax
total dividends
Profits are:
~~
WO
cost of goods sold (as above)
(140)
administrative expenses
..l!fil
45
45
Dividend cover is therefore: - - - - = 5
200 x 0.045
This ignores items on which we have no information . For example, production expenses (other
than purchases), distribution expenses and interest paid/ receivable as well as taxation.
13.3
Answer = B
B would lead to a low price and hence a low PE ratio.
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These conditions remain in force after you have finished
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CBl-14: Interpreting accounts (2)
Page 1
Interpreting accounts (2)
Syllabus objectives
4.2
Interpreting company accounting information:
5.
Calculate and explain accounting ratios that indicate:
•
profitability
•
liquidity
•
efficiency.
CBl-14: Interpreting accounts (2)
Page 2
0
Introduction
There are four main groups of ratios:
1.
Those which measure profitability
2.
Those which measure liquidity
3.
Those which measure business efficiency
4.
Those which relate to the business' financial structure.
We have already discussed the last group, ratios which relate to financial structure (gearing,
etc), In the previous chapter.
In this chapter we will look at the remaining ratios relating to:
1.
Profitability
return on capital employed
profit margin
asset utilisation ratio
return on equity
2.
Liquidity
current ratio
quick ratio (also called acid test or liquidity ratio)
3.
Efficiency
inventory turnover ratio
trade receivables turnover ratio
trade payables turnover ratio.
These will help to indicate how successful the company is in various parts of its operations.
For many ratios, there is no single agreed definition and many variations are used.
As well as defining each ratio, we' ll look at its purpose and, where appropriate, any problems in
calculating it along with some of the common variations.
To illustrate ratio calculations, throughout the chapter we will again use the accounts set out below
for Cover-up Limited, a supplier of specialist equipment and technical advice. From time to time we
will refer back to the next two pages.
CBl-14: Interpreting accounts (2)
Page 3
Statement of profit or loss for Cover-up Ltd for the year 20X0
£000s
250,000
Revenue
Cost of sales:
Cost of stock used :
Raw materials purchased
95,000
Decrease in stocks of finished goods and work-in-progress
7,000
102,000
Depreciation
30.000
(132,000)
Gross profit
118,000
Administrative expenses and other overheads
(85,000)
Operating profit
33,000
Finance income
2,000
Profit before interest and taxation
35,000
Finance costs
(9,950)
Profit before taxation
25,050
Tax
(8,267)
Profit for the year=
16,783
Profit for the year attributable to equity holders of the company
EPS for profit attributable to equity holders
10.Sp
Note to the accounts:
The company proposes to make a dividend payment of £6,000,000, ie 3.75p per ordinary share, in
respect of the year ending 31 December 20X0.
Page4
CBl-14: Interpreting accounts (2)
Statement of financial position for Cover-up Ltd as at 31 December 20X0
£000
ASSETS
Non-current assets
Intangible assets
20,000
Tangible assets
75,000
95,000
Current assets
Inventories
42,000
Trade receivables
60,000
Cash
14,000
116,000
Total assets
211,000
EQUITY AND LIABILITIES
Called up share capital (160 million shares @ 25p)
40,000
Retained earnings
20,000
Other reserves
10,000
Total equity
70,000
Non-current liabilities
10% unsecured loan stock 20X7
25,000
11% subordinated loan stock 20X4
19,000
9¾% mortgage debenture 20XS
16,000
9½% Eurosterling 20X4
40,000
Total non-current liabilities
100, 000
Current liabilities
Trade payables
32,000
Taxation
9,000
Total current liabilities
41,000
Total liabilities
141,000
Total equity and liabilities
211,000
CBl-14: Interpreting accounts (2)
1
Page s
Profitability ratios
The profitability ratios are used to check that the company is generating an acceptable
return for its owners.
A number of benchmarks can be used: previous years' figures, ratios calculated for similar
businesses, Industry averages, etc.
Management should consider the reasons for any ratios which are poorer than expected to
see whether they Imply that performance could be Improved.
1.1
Return on capital employed (ROCE)
Definition
Return on capital employed is the most important profitability ratio - indeed it is often
referred to as the 'primary ratio' or 'return on investment'.
It measures the relationship between the amount Invested In the business and the returns
generated for those Investors.
The calculation of return on capital employed is complicated by the fact that capital employed
can be measured In a number of different ways. It Is vitally Important that the figure for
'return' Is calculated In a consistent manner with that for 'capital employed'.
The two main formulae for return on capital employed are:
profit before tax and interest
----'--------------- X
share capital + reserves + long-term debt
100
and
profit before tax
- - - - - - - - - x100
share capital + reserves
The first formula defines capital employed in terms of the total amount invested in the
company, both by shareholders and lenders. In order to be consistent, the figure for return
must show the total amount generated on behalf of these investors. That is why interest has
been added back.
The second formula defines equity capital employed, in terms of the amount invested by
shareholders only. In order to be consistent, interest is excluded in the numerator as this is
return for bondholders, not shareholders.
The important thing is consistency between denominator and numerator. The two main rules
to obey are:
(i)
if, and only if, an asset is included in the denominator, should the income it gives rise
to be Included In the numerator.
(ii)
if a liability is deducted from the denominator the income paid to it should be
deducted from the numerator.
Page 6
CBl-14: Interpreting accounts (2)
Comments on definition
This ratio is normally expressed as a percentage.
The term 'before interest' means before interest payable but after interest receivable.
The denominator (often called 'capital employed') is virtually the same figure as is used when
calculating asset cover. The definition above uses 'share capital plus reserves plus long-term
debt' which equals 'total assets less current liabilities'. Ignoring any intangibles, the two
definitions are the same.
The ratio is dependent upon the value placed on the assets. Assets revalued upwards might lead
to a higher denominator and a lower numerator, since the depreciation charge would probably
increase in future years.
Purpose
The ratio can be used to indicate how efficiently managers of different firms are using the
funds at their disposal.
It is therefore useful when comparing companies for investment.
A decrease in the ratio would be cause for concern and further investigation, eg to determine
whether profit margins have fallen, sales have fallen or capital has increased without any increase
in profits. Return on capital employed is likely to decrease during recessions, and increase during
booms.
The ratio can be compared with the cost of borrowing.
Return on capital employed can be calculated for parts of a business. If a particular branch
activity produces a very low (high) return on capital employed, then funds should be diverted
away from (towards) that activity.
The ROCE can be broken down into two 'secondary' ratios:
(i)
asset utilisation ratio
revenue (turnover)
share capital + reserves + long-term debt
reflecting the intensity with which assets are employed and:
(ii)
profit margin (or return on sales ratio)
profit before tax and interest
revenue (turnover)
This is an attempt to look at the profits made per unit of sales. It is normal to multiply the
answer by 100 to express it as a percentage.
CBl-14: Inte rpreting acco unts (2)
Page 7
ROCE is the product of these two ratios as follows:
ROCE =
profit before tax and interest
share capital+ reserves+ long-term debt
revenue
profit before tax and interest
= - - - - - - - - - - - - - - -x- - - - - - - - - share capital+ reserves+ long-term debt
revenue
= asset utilisation ratio x profit margin
This shows that a fall in the ROCE can result from two main sources:
•
a fall in the profit per unit of sales {measured by the profit margin)
•
or a fall in the sales generated by the assets (measured by the asset utilisation ratio).
Once management has identif ied the general cause, more ratios can be examined, such as
administration costs per unit of sales, or sales generated by the fixed assets.
Having identified the cause, management can suggest a number of policies, eg pricing policy,
advertising, cost control.
1.2
Profit margin
Variations
We have seen one definition of profit margin above. It is also possible to calculate other sorts of
profit margin, eg the gross profit margin or the operating profit margin.
Operating profit Is sometimes called trading profit.
Remember that operating profit does not include interest receivable. This means that the operating
profit margin is of limited use for most financial companies.
Purpose
Profit margins are useful when analysing the profit made per unit of sale. The difference between
the gross profit margin and the operating profit margin is accounted for by expenses as a
percentage of revenue.
Different industries exhibit vastly different profit margins. In the retailing industry, turnover can
be high and profit margins will often be narrow. However in the drug industry, the margin on a
successful patented drug is much higher.
Pages
CBl-14: Interpreting accounts (2)
Low margins relative to other firms in the industry may indicate a wide range of things, for
example:
•
a more down market product range
•
a 'low margin high volume' marketing strategy
•
an attempt to increase market share
•
poor management/excessive costs
•
temporarily low profits and/or high costs (eg as a new product is launched).
Changes In the profit margin from year to year will also be of Interest to analysts. Such
changes could Indicate changes In any of the Items mentioned above.
Clearly, It Is Impossible to tell whether a high ratio Is good or bad without some further
Information to provide context. A higher ratio could be achieved by Increasing selling
prices. Unfortunately, that could also have the effect of over-pricing the company's
products relative to its competition.
It is also important to bear in mind that different accounting policies can lead to different
profitability ratios. For example, in the IT software industry, one company can seem very much
more profitable than another simply because the latter is prudently writing off unsuccessful or
out-of-date software development costs on software it believes to be out of date.
Many analysts use the profit margin and an estimate of future sales to derive a profits forecast:
Operating profit margin x estimated revenue= estimated operating profit_
1.3
Asset utilisation ratio
This is defined as: _ _ _ _ _ _r_e_ve_n_u_e_ _ _ _ __
share capital + reserves + long-term debt
Pu rpose
This measures the revenue that has been generated by the company's assets. If this has fallen,
the company should investigate the reasons, perhaps:
•
the company has increased its assets but has not used them efficiently
•
the company has encountered production problems
•
revenue has fallen due to a rise in price, a fall in advertising, increased competition or a
recession.
This ratio should be investigated alongside the profit margin. A company might adopt a 'low
margin high volume' strategy which would give the company a high asset utilisation ratio but a
low profit margin.
CBl- 14: Interpreting accounts (2)
Page 9
Return on equity (ROE)
1.4
A further measure of profitability is the return on shareholders' equity:
profit after tax and interest (ie net profit) x
100
share capital + reserves
This ratio doesn't allow for the debt capital employed and also focuses on the net profit for
shareholders.
This is similar to the second formula for ROCE in that the focus is on equity capital and so interest
payments are excluded from the return (ie they are a 'cost' to the shareholders). The difference
between the second ROCE formula and ROE is in the use of returns before tax (ROCE) or after tax
(ROE) .
f
~ Question
t...Li
(i)
(ii)
Calculate the following for Cover-up Ltd:
(a)
profit margin
(b)
return on capital employed (for lenders and shareholders)
(c)
return on equity
Comment on each of these figures.
Solution
(i)(a)
profit margin
=
35,000
= 14%
250, 000
(i)(b)
return on capital employed
=
35,000
170,000
20.6%
(i)(c)
return on equity
=
16,783
70, 000
24.0%
(ii)(a)
The profit margin looks at profits per unit of sales. The figure of 14% can be compared with
other firms in the same industry.
(ii)(b)
Return on capital employed (ROCE) represents how efficiently the firm's capital is being
used to make profits. It can be compared with the opportunity cost of the capital, and also
with other firms in the same industry. An ROCE of 20.6% would seem to cover the cost of
capital.
(ii)(c)
Return on equity (ROE) focuses on the rate of return being earned on shareholders' equity
capital. An ROE of 24.0% may indicate that the company is making good use of (cheaper)
debt finance to enhance returns to shareholders. An alternative interpretation is that the
gap between this and the previous ratio indicates that the company has a large amount of
debt in its capital structure which may be a concern to the shareholders.
CBl- 14: Interpret ing accounts (2)
Page 10
2
Liquidity ratios
While it is important for a business to be profitable, profit is not sufficient on its own to
guarantee survival. There must be sufficient liquid assets available to ensure that shorttenn commitments can be met. Otherwise the company could be forced into liquidation.
2.1
Current ratio
current ratio =
current assets
current liabilities
Purpose
This ratio is used to assess whether the company will be able to pay its bills over the next
few months.
It provides a comparison of an estimate of the amount of money due to be received In the
short term with an estimate of the amount of money to be paid.
Liquidity is important. Many profitable firms have:
•
had to go to their shareholders to raise extra cash when liquidity has become a problem
•
been wound up because they have had insufficient cash to meet their short-term liabilities.
No.rmally, a low ratio might Indicate that a company may have problems paying Its creditors.
An excessively high ratio may Indicate that the management has too much money tied up In
unproductive short-term assets.
Unproductive assets could include assets such as excessive stocks or idle cash balances. 'Too
high' will vary according to the nature of the industry, eg whether large stocks are needed or
what the normal credit terms are fo r doing business with suppliers and customers.
It is difficult to know exactly what a low or high figure Is for any given company. Different
Industries can have very different 'normal' levels. In general, a ratio of 2:1 ls considered to
be optimal.
This could, however, be excessive for businesses wh ich have rapid turnover of inventory
and steady cash inflow (a supermarket being the classic example). By the same token, a
ratio of 2:1 might be inadequate for a business which has irregular cash inflows.
Because of this, many analysts use the ratio to look at trends over a number of years. A
sudden change would be cause for further Investigation.
The company's creditors may also be very interested in using the current ratio to assess a firm's
short-term solvency.
Comments on definition
The accounts are usually only available several weeks or months after the date at which they are
completed and so short-term figures such as current asset and liabilities may be out of date by
the time the accounts are published .
CBl-14: Interpreting accounts (2)
Page 11
A key liquidity factor for many companies is the size of their unused overdraft limit. However, this is
something that only a few companies choose to report. The current ratio is therefore a very crude
indicator of a company's ability to meet its short-term debts.
The term 'current liabilities' will usually be taken to mean 'creditors falling due within one
year'.
The figures in the statement of financial position will only include those assets and liabilities which
exist at that date.
There is no guarantee that the time span of the current assets is the same as the time span of the
current liabilities. So a company with an apparently satisfactory current ratio might still have
trouble paying a liability due tomorrow. In particular, inventories are included in the numerator, but
it may take some time to complete and sell the finished product, and then await payment.
As with all ratios, usefulness depends upon the reliability of the values shown in the accounts. In
particular, the value placed on inventories will depend upon the accounting methods used. The
current ratio may therefore be slightly misleading when used to compare different firms.
2.2
Quick ratio
quick ratio =
current assets - inventories
current liabilities
The quick ratio is also known as the acid test, or the liquidity ratio.
Purpose
This is another ratio aimed at looking at short-term liquidity.
The quick ratio considers what would happen if all creditor and debtor accounts were
settled immediately. It focuses on readily realisable cash.
The idea is that only cash and trade receivables (debtors) can be quickly turned into cash, but any
of the current liabilities could become payable within a few months.
A quick ratio of much less than one might be a sign that the company may struggle to pay
its creditors. However some companies are able to survive with a ratio of much less than
one.
This is because their customers pay in cash, but they agree and continually roll-over, say, 90-day
credit terms with their suppliers without any problems.
Again, it is often departures from the normal level of the ratio rather than the absolute level
of the ratio which will Interest analysts.
And again, true liquidity is often more dependent upon agreements with bankers, than on the ratio.
Variations
Any marketable investments could be included in the numerator. However, these are often ignored
in practice (and in exams) since the information to decide on the marketability of an investment
may not be available.
Page 12
CBl-14: Interpreting accounts (2)
f:
Question
/i' - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - (i)
(ii)
Calculate the following for Cover-up Ltd:
(a)
current ratio
(b)
quick ratio
Comment on each of these figures.
Solution
(i)(a)
current ratio
= 116,000 = 2.8
(i)(b)
quick ratio
= 116,000-42,000 =1.8
(ii)(a)
The current ratio gives an estimate of the company's liquidity. It compares money due to
41,000
41,000
be received soon with money due to be paid soon. The figure of 2.8 indicates that Cover-up
is able to cover its short-term debt.
(ii)(b)
The quick ratio also gives a measure of liquidity. It uses only the cash or near-cash items in
the statement of financial position (as stocks may take a while to sell). A ratio of 1.8
indicates that the company is solvent in the short term.
CBl-14: Interpreting acco unts (2)
3
Page 13
Efficiency ratios
The efficiency ratios are related to the liquidity ratios.
They give an insight into the effectiveness of the company's management of the
components of working capital (current assets less current liabilities).
These ratios tend to be multiplied by 365 and so expressed as a period of time.
Most of the ratios below assume we are examining annual accounts and hence include a' x 365'
factor. If we are examining monthly accounts (eg internal management accounts) we should adjust
accordingly for the different day count, eg replace the 'x365 ' by 'x 365 / 12 ' or' x 31 '.
3.1
Inventory turnover period
The inventory turnover period is defined as:
Inventory tumover period = Inventories x 365
cost of sales
Purpose
This Is an attempt to assess how much Inventory the company holds In relation to the scale
of the company"s operations. The ratio attempts to show how long inventory is held for on
average.
Inventory turnover period of, say, 1/12 of 365 days would suggest that the average item of
inventory is held for one month.
An Inventory turnover period that Is less rapid than other companies In the same Industry
might Indicate an Inefficiently large Inventory holding.
An increasing ratio might indicate slowing sales and stockpiling of unsold goods.
This ratio will vary enormously between businesses.
The inventory turnover ratios of a ship builder and a fresh fish retailer, for example, are likely to be
very different.
Inventory turnover is meaningless when considering a financial institution such as a bank.
Comments on definition
Inventories include finished goods, work-in-progress and raw materials.
One difficulty with the ratio is that the figure for inventories may be subject to seasonal
variation.
So using end-year statement of financial position values is potentially misleading. There is very
little that an analyst can do about this.
Also, the value placed on Inventories will depend upon the accounting method used.
Page 14
CBl-14: Interpreting accounts (2)
The figure for inventories comes from the statement of financial position, and the revenue figure
from the statement of profit or loss. Some analysts will use the latest available figure for
inventories, others will use an average of the start and end-year figures.
t ,r·
Question
Explain why it is a good idea to use an average of the start and end-year statement of financial
position figures for inventories when calculating the inventory turnover period.
Solution
Stock turnover is one of the accounting ratios that use a combination of figures from the statement
of financial position and figures from the statement of profit or loss.
The statement of financial position is a set of figures that are correct on a particular date, whereas
the statement of profit or loss covers a period of time (normally a year).
Some analysts therefore use an average figure for this item in the statement of financial position in
order to attempt to reconcile this discrepancy in timing between the two sets of accounts.
t .,¥
Question
Explain what the inverse of the inventory turnover period (multiplied by 365) tells the analyst.
Solution
The inverse of the inventory turnover period tells the analyst how many times the inventory is
turned over in an accounting period.
A variation on the definition of inventory turnover period is to use sales revenue as the
denominator, ie:
inventory turnover period =
3.2
inventories
x
365
sales revenue (turnover)
Trade receivables turnover period
.
.
trade receivables
trade receivables turnover period = - - - - - - - x 365
credit sales
Purpose
This is a measure of the average length of time taken for trade receivables to settle their
balance.
Again, It Is desirable for this period to be as short as possible. It will be better for the
company's cashflow if those owing the company money pay as quickly as possible. It can,
however, be difficult to press for speedier payment. Doing so could damage the company's
relationship with Its customers.
CB1-14: Interpreting accounts {2)
Page 15
Comments on definition
This ratio indicates the average number of days credit that is extended to customers paying by
credit.
'Credit sales' refers only to that part of the total sales of the company which were transacted on
credit, excluding the sales for cash.
If the company sells goods for cash and for credit then it is important to divide the trade
receivables figure by credit sales only.
The split between sales for credit and sales for cash is not often published.
If you are analysing a real set of financial statements then many companies will have sales
that are generally either all on credit or all for cash (in which case the ratio would not apply).
Where it is realistic to assume that all sales are on credit, the ratio can be simplified to:
.
.
trade receivables
trade receivables turnover period = - - - - - - - x 365
sales
If sales cannot be broken down then the ratio will be distorted.
However if the proportion of cash versus credit sales remains constant from year to year, the figu r es
for different years can be compared, even if there is a theoretical distortion.
3.3
Trade payables turnover period
A similar ratio can be used to assess trade payables:
.
trade payables
trade payables turnover penod = - - - - - - x 365
credit purchases
This ratio indicates the average number of days credit that a company has from its suppliers. A
high ratio indicates that the company is taking a long time to pay its bills. This may be because it
has been able to obtain a long credit period from its supplier s, which will be of benefit to its
cashflow.
Comments on definition
It can be difficult to calculate this ratio in the real world because companies do not disclose
their purchases figure.
In some ca ses it will be reasonable to assume that all purchases involve some form of credit and
so use total purchases (ie inventory used plus incre ase in stock over th e year) inst ea d.
It is possible to obtain a crude estimate of the period by using cost of sales as a surrogate
for purchases.
Another commonly u sed variation is to use sales revenue as the denominator. This results in sales
revenue pote ntia lly being used as the deno minator in each of t he three efficiency ratios, even
t hough it is not the ideal choice f or any of the three when ot her figures are available.
Page 16
3.4
CBl-14: Interpreting accounts (2)
Bringing the efficiency ratios together
The three efficiency ratios can be combined to calculate the average time from payment to
suppliers for the materials to receiving cash from the sale of goods produced from the materials,
ie the average period of time for which a company has cash tied up in inventories. This is known
as the working capital cycle and is equal to:
inventory turnover period+ trade receivables turnover period
- trade payables turnover period.
A shorter period enables the company to generate cash faster and reduces the need for liquid
assets and external financing.
For example, suppose we have calculated the three efficiency ratios with the following results:
•
inventory turnover period = 32 days
•
trade receivables turnover period = 44 days
•
trade payables turnover period = 39 days.
This suggests that the company takes 32 days to sell an item of inventory. If it is sold on credit,
this will result in a trade receivable which will then take an average of 44 days for settlement. So,
it takes a total of 32 + 44 = 76 days from the acquisition of an item of inventory until there is cash
flowing in from its subsequent sale and the customer's settlement.
However, the company only pays for goods on average 39 days after their purchase. This means
that it does not have cash tied up in this sequence until day 39 and so the company only has cash
committed for a total of 76 - 39 = 37 days.
f ~
Question
(i)
(ii)
Calculate the following for Cover- up Ltd:
(a)
inventory turnover period
(b)
trade receivables turnover period (assume 80% of the sales are for credit)
(c)
trade payables turnover period (assume all purchases are for credit)
(d)
average period of time for which Cover-up has cash t ied up in inventories.
Comment on each of these figures.
CBl-14: Interpreting accounts (2)
Page 17
Solution
(i)(a)
inventory turnover period
=
42 000
'
x 365 = 116 days
132,000
(i)(b)
trade receivables turnover period
=
60
' ooo
x 365 = 110 days
0.8 X 250,000
(i)(c)
trade payables turnover period
=
32 000
'
x 365 = 123 days
95,000
(i)(d)
average period of time for which Cover-up has cash tied up in inventories
=116 + 110-123 =103 days
(ii)(a)
The inventory turnover period shows how quickly the company is selling its output. The
figure indicates that the company is turning over its inventory every 116 days
ie approximately every four months.
(ii)(b)
The trade receivables turnover period indicates the number of days credit that is extended
to customers who request payment on credit. The ratio of 110 days is quite high, indicating
that the company is not operating its credit control function effectively.
(ii)(c)
The trade payables turnover period is also quite high at 123 days. Cover-up may have been
able to negotiate good credit terms from its suppliers.
(ii)(d)
The time from payment to suppliers to receiving cash from the sale of goods is 103 days,
ie just over 3 months. This is mainly driven by the time taken to turn over the inventory, as
the company is taking longer on average to pay its suppliers than it is to collect payment
from its customers. The time taken to pay suppliers appears to be conscious decision as the
current and quick ratios suggest liquidity is not constraining the company's ability to make
these payments.
Page 18
CBl-14: Interpreting accounts (2)
The chapter summary starts on the next page so that you can
keep all the chapter summaries together for revision purposes.
Page 19
CBl- 14: Interpreting accounts (2)
Chapter 14 Summary
Profitability ratios
profit before tax and interest
Return on capital employed = - - - - - - - - - - - - - share capital + reserves + long-term debt
revenue (turnover)
Asset utilisation ratio = - - - - - - - - - - - - - - share capital + reserves + long-term debt
profit before tax and interest
Profit margin = - - - - - - - - - revenue (turnover)
.
.
gross profit
Gross profit margin = - - - - - - revenue (turnover)
Return on equity =
profit after tax and interest
share capital + reserves
Liquidity ratios
Current ratio =
current assets
current liabilities
current assets - inventories
Quick ratio= - - - - - - - - - current liabilities
Efficiency ratios
Inventory turnover period
or inventories x
= inventories x
365
365
cost of sales
revenue
Trade receivables turnover period = trade receivables x 365
credit sales
.
payables
Payables turnover period = - - - - - - x 365
credit purchases
For monthly accounts, replace 'x365' by 'x365/12'.
Page 20
CBl-14: Interpreting accounts (2)
The practice questions start on the next page so that you can
keep the chapter summaries together.
CBl-14: Interpreting accounts (2)
Page21
~~ Chapter 14 Practice Questions
14.1
Exam style
A company's operating profit for the year, before allowing for interest, was $30m. Its
share capital was $15m, share premium $6m, revaluation reserve $1m, retained earnings $8m,
long term borrowings $10m and overdraft $Sm.
Calculate the capital employed figure that would enable you to calculate the company's return on
capital employed ratio.
A
B
C
D
$32m
$34m
$40m
$45m
The next two questions refer to PRP pie. The following details relate to PRP pie:
14.2
Exam style
14.3
Exam style
14.4
•
Revenue
£103,250
•
Pre-tax profit
£57,000
•
Tax for the year
£1,200
•
•
12% loan stock
£15,000
Share capital and reserves
£425,000
•
Non-current assets
£55,000
Calculate PRP's return on capital employed for the year.
A
B
12.68%
12.95%
C
D
13.36%
13.84%
Calculate PRP's profit margin for the year.
A
56.95%
B
55.21%
C
D
54.04%
53.46%
An analyst is assessing Company R's performance relative to its main competitor, Company S. The
analyst has noticed that S's profit margins are lower than R's. Which TWO of the following best
explain this?
A
S has recently lowered its prices in an attempt to increase its market share.
B
S paid a large dividend to its shareholders during the year.
C
S has a much higher corporation tax bill than R.
D
E
S is less efficient at managing its working capital than R.
S offers a basic range of products while R offers a premium product range.
Page 22
14.5
Exam style
CBl-14: Interpreting accounts (2)
The following information is available for Drummer pie, a manufacturing company, for calendar
years 20Y2 and 20Yl :
20Y1
20Y1
Revenue (£000)
56,000
45,000
Profit before tax and interest (£000)
3,053
2,915
Share capital+ reserves+ long-term debt (£000)
35,141
27,832
Profit margin
5.5%
6.5%
Asset utilisation ratio
1.59
1.62
Return on capital employed
8.7%
10.5%
Figures from financial statements
Profitability ratios
During the year to 31 December 20Y2 there was a restructuring and a marketing initiative to
increase sales, largely financed by taking out a long-term loan.
The following three statements relate to Drummer pie's profitability:
The additional profit generated in 20Y2 is not sufficient to offset the impact of the higher
capital employed coming from the increased borrowing.
II
The company's expenses have risen proportionately more than its sales revenue.
Ill
The company is generating more revenue per£ of assets in 20Y2 than it did in 20Yl.
Which of the statements is/are true?
A
B
I only
II and Ill only
C
I and II only
D
Ill only
Page 23
CBl-14: Interpreting accounts (2)
Exa m style
The next four questions are based on the following figures from ABC Ltd's accounts. Unless stated
otherwise the figures are as at the end of the financial year:
£000
14.6
Sales
200
Inventories at the beginning of the year
30
Inventories at the end of the year
20
Purchases
130
Administrative expenses
15
Trade receivables
40
Prepayments
3
Cash
17
Bank overdraft
12
Trade payables
10
Accruals
2
The average inventory turnover period of ABC Ltd in days is :
A
B
C
D
14.7
36 days
46 days
65 days
78 days
Consider both Statement 1 and Statement 2 and decide, for each statement, whether it is true or
false.
If, and only if, you consider both statements to be true, you must decide whether Statement 2 is a
valid explanation as to why Statement 1 is true .
Statement 2 (Reason)
Statement 1 (Assertion)
It is not possible to assess how
efficiently ABC Ltd's inventory is
managed using the information
provided.
14.8
BECAUSE
The inventory turnover period
depends on the production cycle of
the industry.
A
B
1 true, 2 true, 2 is a valid explanation to support 1
1 true, 2 true, 2 is NOT a valid explanation to support 1
C
D
E
1 true, 2 false
1 false, 2 true
1 false, 2 false
Calculate ABC Ltd' s current ratio to 1 decimal place.
Page 24
14.9
CBl-14: Interpreting accounts (2)
Which TWO of the following are true about a company's liquidity ratios?
A
B
C
D
E
If the quick ratio is less than one, it indicates that the company will be unable to pay its
creditors on time.
Analysts only need to look at the liquidity ratios for the current year in order to assess a
company's liquidity position.
A company's current ratio is likely to be of particular interest to its creditors.
Too high a current ratio may indicate that assets are not being used effectively to provide
a return for shareholders.
A company's liquidity ratios are of little interest to shareholders as the shareholders' main
focus is how much profit the company is making.
Although not an exam-style question, you may find it helpful practice to calculate a range of ratios
and consider their interpretation. The next question provides an opportunity to do this.
CBl -14: Interpr eting accounts (2)
14.10
Page 25
Shown below are the statements of financial position as at 31 December 20XS and 31 December
20X4 for K Kitchens, a chain of cookshops.
KKitchens
Statements offinancial position
31/12/20X5
31/12/20X4
£
£
Land and buildings
700,000
800,000
Trademark
90,000
Investments
400,000
ASSETS
Non-current assets
1,190,000
800,000
Inventories
429,500
425,000
Cash
34,500
125,000
Trade receivables
38,000
28,000
502,000
578,000
1,692,000
1,378,000
Share capital (£1 par value)
700,000
700,000
Other reserves
200,000
200,000
Retained earnings
251,500
225,500
1,151,500
1,125,500
Current assets
Total assets
EQUITY AND LIABILITIES
Total equity
Non-current liabilities
8% Convertible unsecured loan 20X8
200,000
10% Debenture 20X7
100, 000
12% Unsecured Loan Stock 20X9
150,000
150,000
450,000
150,000
Trade payables
68,000
51,000
Tax due
12,500
26,500
Overdraft
10,000
25,000
90,500
102,500
540,500
252,500
1,692,000
1,378,000
Current liabilities
Total liabilities
Total equity and liabilities
Page 26
CBl-14: Interpreting accounts (2)
During the year to 31 December 20XS, the following events occurred:
•
In January, the company bought shares in C Cookware for £400,000. This was financed by
the issue of the 8% Convertible Unsecured Loan Stock 20X8, and 10% Debentures 20X7.
The loan stock were issued at par. The remaining £100,000 was paid for out of cash .
•
In January, the company also acquired the exclusive rights to sell a new trademarked
design of kitchenware, for a price of £100,000. It has shown these rights as an asset in its
statement of financial position, and is depreciating them using the straight line method
over 10 years.
•
The company's operating profit for 20X4 was £243,000, on revenue of £1,215,000.
Revenue increased by 3% in 20XS, and operating profit was £120,000. The company paid
the interest on its loan stocks in full.
Calculate the following ratios for K Kitchens for 20X4 and 20XS and use them to comment on the
company's performance during that period in terms of profitability, efficiency and liquidity:
•
•
•
profit margin
•
current ratio
•
quick ratio .
return on capital employed
inventory turnover period
CBl-14: Interpreting accounts (2)
Page 27
Ill Chapter 14 Solutions
r-,
14.1
Answer = C
The capital employed (the denominator of the ROCE ratio) is share capital+ reserves+ long-term
debt. Reserves include share premium account, revaluation reserve and retained earnings. So,
capital employed is $1Sm +$Gm+ $1m +$Sm+ $10m = $40m.
The ROCE could be defined using only equity capital, ie $30m in this case, but this is not offered as
an option.
14.2
Answer = C
Return on capital employed is : profit before tax and interest or profit before ta x
long-term debt and equity
equity
To find the figure for profit before tax and interest, we need to add the loan stock interest back
onto the pre-tax profit .
57, 000 +(15,000 x 0.12)
The calculation is then - - - - - - - - = 13 .36%
425,000+15,000
The other definition of return on capital employed, ie profit before tax/ equity, is not offered as
an option .
14.3
Answer = A
·t
. . profit before tax and interest
Pro f I margin 1s: - ' - - - - - - - - - - - revenue
14.4
57, 000+(15,000 x 0.12) = _ %
56 95
103, 250
Answers = A and E
A and E are correct since lowering prices and offering lower quality products will both reduce
revenue, which in turn will reduce profit margins. While lower quality products may also cost less
to produce (meaning less of an impact on the gross profit margin), the company will still need to
pay its fixed costs, eg rent.
Band Care incorrect since dividends and tax do not affect profits before tax and interest. Dis
incorrect since the management of working capital does not have a direct effect on revenue or
profit.
14.5
Answer = C
We can see that statement I is true by looking at the return on capital employed (ROCE) for the
two years. ROCE has decreased year-on-year, meaning that while profit has increased in absolute
terms, it has not increased enough to offset the higher levels of capital employed.
We can see that statement II is true by looking at the profit margins for the two years. The lower
profit margin for 20Y2 means that that Drummer pie' s expenses have risen proportionately more
than sales revenue.
CBl-14: Inte rpreting accounts (2)
Page28
We can see that statement Ill is false by looking at the asset utilisation ratios for the two years.
The asset utilisation ratio has fallen slightly year-on-year, suggesting that the company is
generating slightly less revenue per£ of assets. Although sales revenue has risen by 24%, capital
employed has risen by 26%.
14.6
Answer = C
The question asks for the average inventory turnover period. This means that the value of
inventories should be the average of the start and end year figures (ie 25)
The cost of sales= opening inventory+ purchases - closing inventory= 30 + 130- 20 = 140
The inventory turnover period in days is therefore:
inventories x 365 = 25 x 365 = 65 days
140
cost of sales
14.7
Answer = A
It is difficult to comment on whether ABC Ltd is managing its inventory efficiently given the
limited information in the question. For example, we don't know what industry ABC Ltd operates
in. If the goods sold by the company have a limited shelf life (eg fresh food) then an inventory
turnover period of 65 days is unlikely to be appropriate. On the other hand, if the inventory is not
perishable and ABC Ltd takes advantage of bulk discounts from its suppliers, then 65 days may be
perfectly fine. In other words, the production cycle of the industry in which ABC operates will
determine the inventory turnover period to a large extent.
14.8
The current ratio is calculated as fo ll ows:
current assets
.
current ratio= - - - - - current liabilities
In this case current assets consist of closing inventories, trade receivables, prepayments
(ie payments made for goods that have not yet been received) and cash.
In this case current liabilities (ie creditors falling due within one year) consist of overdrafts, trade
payables and accruals (expenses which have been incurred in the period but which will be paid for
in a later period, eg gas bills).
So, the current ratio is:
20 40 3 17
+ + + =3 .33
12+10+2
CBl-14: Interpreting accounts (2)
14.9
Page 29
Answers = C and D
A is incorrect because while a quick ratio of less than one might indicate that the company will
struggle to pay its creditors on time, some companies are able to survive with a quick ratio of well
below one.
Bis incorrect since analysts need to understand trends in a company's liquidity ratios. This will
help them to understand what is 'normal' for that particular company. Departures from the norm
will be of interest to analysts.
Profitable companies can go out of business if they do not have enough cash to fund their day-today operations. As a result, a company's liquidity is of interest to shareholders as well as
profitability. Eis therefore incorrect.
14.10 Profitability
243 ooo
Profit before tax and interest
. 20X4: - - - - - - - - - - - =
'
-- 20%
I margin
Pro f ·t
1,215,000
revenue
Profit margin 20XS:
12
0,000
= 9.6%
1,215,000 x 1.03
ROCE 20X4 : profit before tax and interest = 243,000 = 19 _1 %
long-term debt+ equity
1,275,500
ROCE 20XS: 120,000
= 7.5%
1,601,500
The profit margin has fallen from 20% to 9.6%. This is mostly because trading profit has halved
over the year. We do not have any information to say why this has happened, but it is a matter
that requires further investigation.
The return on capital employed has fallen even further, from 19.1% to 7.5%. The fall in operating
profits is exacerbated in this case by the increase in the capital employed (share capital and
reserves plus debt).
This increase comes from the new loan stocks which were issued in order to finance the purchase
of C Cookware shares.
The new ROCE is lower than the cost of borrowing on the new debentures (10%), so investors in
the company will be concerned that the money raised is not being used efficiently.
Efficiency
Inventory turnover period (in days, based on revenue as cost of sales is not available).
·. inventories
425,000
d
2ox4 - - - - x365 = ----x365 =128 ays
revenue
1,215,000
20XS:
429 ,soo x 365 = 125 days
1,251 , 450
Page30
CBl-14: Interpreting accounts (2)
This has remained reasonably constant over the two years, so there does not appear to be any
improvement or deterioration in efficiency. However, we need to know the equivalent period for
other firms in the same line of business, to see how K Kitchens compares.
Liquidity
.
X
Current ratio 20 4 :
current assets = 578, 000 __ S.G
current liabilities 102,500
Current ratio 20XS:
soi,ooo = 5.5
90,500
current assets - inventories 153, 000
Quick ratio 20X4: - - - - - - - - - - - - - 1.49
current liabilities
102,500
Quick ratio 20XS :
72
,soo = 0.80
90,500
Both the current ratio and the quick ratio have decreased over the year. The current ratio was at
5.6, and has dropped slightly to S.S.
At first glance these look like high figures for this ratio, but we would need to compare with other
firms in the same industry to make a judgement about this.
The quick ratio has fallen from 1.49 to 0.80. This indicates that if the company were required to
settle its short-term debts in a hurry, it would not be able to do so.
Investors in the company may be concerned about this. The company would need to check its
banking facilities - whether it would be able to increase its overdraft to cover a 'cash crisis' .
The reduction in the quick ratio is largely due to the cash cost of acquiring the trademark and the
shares in C Cookware, but may be temporary if these assets generate cash in the future.
The difference between the current ratio and the quick ratio highlights the fact that the company
holds a large quantity of inventory. Indeed, in 20XS, over 85% of its current assets were in the
form of unsold inventory.
Investors in the company might question whether the company needs to change (a) its policy on
buying inventory and (b) its pricing policy, in order to reduce this high level of inventory.
However, in order to make a more informed comment, we would need to look at the levels of
inventory held by similar companies.
CBl-14: Interpreting accounts (2)
Page 31
End of Part 4
What next?
1.
Briefly review the key areas of Part 4 and/or re-read the summaries at the end of
Chapters 12 to 14.
2.
Ensure you have attempted some of the Practice Questions at the end of each chapter in
Part 4. If you don't have time to do them all, you could save the remainder for use as part
of your revision.
3.
Attempt Assignment X4.
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CBl-15: Use of derivatives
Pagel
Use of derivatives
Syllabus objectives
2.3
Principal forms of financial instrument issued or used by private companies and the
ways in which they may be issued:
5.
Characteristics and possible uses by a non-financial company of:
•
financial futures
•
options
•
interest rate and currency swaps.
Page 2
0
CBl-15: Use of derivatives
Introduction
In the remainder of the course we study in more detail various decisions that companies have to
make, eg whether and how to grow, which projects to invest in, how to obtain the necessary
finance and how to manage the associated risks. In this chapter we study derivatives, which are
one of the tools that companies have available as part of their risk management strategy.
A derivative is a financial instrument with a value dependent on (or derived from) the value of
some other asset(s). After defining various derivatives, this chapter concentrates on their use by
non-financial companies, which is mainly to manage financial risk. The aim is to show how
derivatives serve a real purpose in the commercial world , rather than being abstract financial
products of use only to the financial world.
The chapter is divided into three sections. We look at financial futures in Section 1, options in
Section 2 and swaps in Section 3.
The examination could test, for example, knowledge ofthe features of derivative products and
the ability to determine what will be an appropriate derivative product for a particular situation.
CBl-15: Use of derivatives
1
Financial futures
1.1
Introduction
Page3
Definition
Q A futures contract is a standardised, exchange tradeable contract between two parties to
-
trade a specified asset on a set date in the future at a specified price.
Futures were originally developed for agricultural and other commodities. Chicago developed an
important market in the trading of wheat, pork belly and coffee futures. Gold, silver and copper
soon developed their own futures markets.
Financia/futures are based on an underlying financial instrument, rather than a physical
commodity.
We distinguish between futures and forwards. A forward is an agreement between two parties to
trade a specified asset at a set date in the future at a set price. For example, Company Z could
enter into a forward contract to buy a certain type of bond at a set price at a set date in the
future. This is a two-party deal, tailor-made to suit Company Zand the seller, and Company Z
cannot sell this contract on to anyone else.
Futures differ from forwards in that futures are standardised and exchange tradeable. If
Company Z had bought a future, it would be a standardised contract (ie not tailor-made) that
could be sold on.
Categories
Financial futures exist in four main categories:
•
bond futures
•
short interest rate futures
•
stock index futures
•
currency futures.
Individual stock futures are also available in some markets.
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Page4
Margins
When you enter into a futures contract to buy or sell an asset, the price is fixed today but
payment is not made until later. For example, you might agree to buy a bond future at £94,000 in
three months' time. You pay just a deposit now.
Each party to a futures contract must deposit a sum of money known as margin with the
clearing house. Margin payments act as a cushion against potential losses which the
parties may suffer from future adverse price movements.
When the contract is first struck, initial margin is deposited with the clearing house.
For example, you (and the other party to the future) might be asked to pay initial margin of £500.
Additional payments of variation margin are made dally to ensure that the clearing house's
exposure to credit risk is controlled. This exposure can increase after the contract is struck
through subsequent adverse price movements.
For example, if the price of bond futures fell to £93,000 the following day, then you as the buyer
would have made a loss of £1,000, whereas the seller would have made a profit of £1,000. You as
the buyer would have £1,000 deducted from your margin account, and may have to top it up by
paying the clearing house £1,000, and the seller's margin account with the clearing house would
increase by £1,000, which could be removed by the seller from the account.
In this way, the clearing house protects itself by settling up profits and losses each day.
Shortly before the contract is due to expire, the buyer and the seller normally 'close out' the
futures position, ie neutralise existing contracts by entering into equal but opposite contracts, and
the clearing house returns the money in each margin account. For example, having entered into a
futures contract to buy a bond in three months' time, the position could be closed out the day
before expiry by entering into a futures contract to sell the same bond in one day's time.
tr
~ v _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __
Question
Explain why it is necessary for the exchange to require that companies trading futures contracts
deposit margin when they trade.
Solution
The exchange assumes responsibility for the settlement of all contracts. Therefore it assumes
substantial credit risk itself, in that if any trader fails to settle, then the exchange must settle the
deal on their behalf and suffer any loss. For this reason the exchange insists that traders deposit
sufficient funds to cover:
•
the current negative value of any outstanding contracts
•
an extra amount to cover any likely future volatility in the contract over a short period.
The exact rules for determining margin amounts are complex, and vary from contract to contract.
CBl-15: Use of derivatives
Page s
In financial futures, 'delivery' rarely takes place - most deals are 'cash settled'. In the example
above, the bond is unlikely to be delivered - profits or losses are made by the movements in the
price of the bond future and are realised through the variation margin payments.
1.2
Types of financial futures
Bond futures
For delivery, the contract requires physical delivery of a bond. If the contract were specified
in terms of a particular bond then it would be possible simply to deliver the required amount
of that stock. If the contract is specified in terms of a notional stock then there needs to be
a linkage between it and the cash market. The bonds which are eligible for delivery are
listed by the exchange. The party delivering the bond will choose the stock from the list
which is cheapest to deliver. The price paid by the receiving party is adjusted to allow for
the fact that the coupon may not be equal to that of the notional bond which underlies the
contract settlement price.
For example, a bond future might have the following features:
Long bond future
Unit of trading:
£100,000 nominal value government bond with 4% coupon
Delivery month :
March, June, September, December
Quotation:
per £100 nominal
The settlement of such a future involves buying or selling a prescribed nominal amount of an
actual government bond (from a list maintained by the exchange) on the exercise date.
Short interest rate futures
For example, a short interest rate future might have the following features:
3-month interest rate future
This is based on an artificial index which is defined as :
Index= 100- (4 x the implied 3-month interest rate expressed as a percentage)
For example, if the implied (ie the rate that investors expect at the expiry of the contract)
interbank 3-month rate were 0.5% (or 2% pa), then the index would stand at 98. An investor can
buy or sell this index as if it were a normal asset. Indeed, being an exchange traded contract, the
investor can sell it before buying it (known as going 'short' on the index). Provided the investor
buys it back before expiry they need never deliver it. This is very common.
The way that the quotation is structured means that as interest rates fall the price rises, and
vice versa.
The price is stated as 100 minus the 3-month interest rate. For example, with an interest
rate of 6.25% the future is priced as 93. 75.
Page6
CBl -15: Use of derivatives
If interest rates fall from 6.25% pa to 5% pa, the price of the interest rate future rises from 93. 75
to 95. This means that the inverse relationship between price and interest rates applies to
interest rate futures as well as bonds.
The contract is based on the interest paid on a notional deposit for a specified period from
the expiry of the future.
However no principal or interest changes hands. The contract is cash settled. On expiry
the purchaser will have made a profit (or loss) related to the difference between the final
settlement price and the original dealing price. The party delivering the contract will have
made a corresponding loss (or profit).
Remember that futures contracts are effectively settled up every day by the use of variation
margin. Profits and losses are calculated daily. At expiry, the final day's profit or loss is
calculated, variation margin is paid to or received from the clearing house and the margin account
balance is returned to both parties. The notional deposit on which the contract is based is not
exchanged.
Stock index futures
The contract provides for a notional transfer of assets underlying a stock index at a
specified price on a specified date.
Currency futures
The contract requires the delivery of a set amount of a given currency on the specified date.
1.3
Uses of financial futures
Q A company can use financial futures to 'lock In' the value of assets or liabilities, or to
-
guarantee the value of receipts and payments.
There are many circumstances that can lead a company to use the financial futures market, some
are more obvious than others. Some examples for each of the above contract types are described
below.
Bond futures
When issuing bonds
If a company intends to issue bonds in the future but wishes to lock in the current level of yields,
it could sell some bond futures contracts at the current price, thereby locking in current yields.
This futures position would be unwound when the actual bond is issued.
For example, suppose the company agrees to sell bonds at the current price of (say) 110
in 3 months' time (the time of the proposed issue of the new bonds). If the price subsequently
increases to 120, then the company will lose on the future (it has to sell bonds worth 120 for only
110) but gain from higher bond prices by being able to obtain a higher price for the issue of its
bonds. On the other hand, if the price falls to 100, the company's gain on the future will be offset
by the lower bond issue price.
CBl-15: Use of derivatives
Page7
When it has a fixed-rate loan
A company could agree to buy bond futures contracts to hedge the risk of interest rates falling if it
has a fixed-interest rate loan.
If interest rates fell, bond prices would rise, and therefore the company would offset the 'loss'
from being unable to benefit from the fall in interest rates on its loan with a 'gain' on its bond
futures. Similarly, if interest rates rose, bond prices would fall and therefore the company would
gain from its fixed interest rate loan but lose on its bond futures.
Short interest rate future
When it has a floating-rate loan
A company could use interest rate futures to protect it from the risk of rising interest rates.
For example, If a company has raised capital by borrowing at floating Interest rates, but
wishes to fix Its future Interest payments, It can use Interest rate futures to fund any
increase in the interest rate payable (but will have to pay over any interest saved if market
rates fall).
Suppose a company has to borrow in three months' time and is worried that interest rates will
rise from the current rate of, let's say, 4% pa. It could lock in the current interest rate by selling
short interest rate futures. It could agree to sell sufficient contracts at the current price of 96 to
hedge its borrowing costs in three months' time.
If interest rates rose to 6% pa over the next three months, the price of the interest rate future
would fall to 94. The profit the company would have made on the sale of this future (which was
sold at 96 and could be bought back at 94) would offset the company's higher borrowing costs.
If interest rates fell to 2% pa over the next three months, the company could borrow at a lower
cost than it expected. However any profit from the lower borrowing costs would be offset by the
loss on the interest rate future contracts.
Stock index futures
During a takeover
During a takeover, a rise in the target company's share price can cause an increase in the amount
the predator company has to pay (assuming that part of the offer is 'for cash' and that the cash
needed to pay for the target company will increase if its share price goes up). The predator
company can buy stock index futures to hedge this risk.
Pages
CB1-1S: Use of derivatives
f I Question
t /r
Outline how stock index futures could help hedge the risk that share prices rise during a takeover
bid.
Solution
The predator company could purchase sufficient stock index futures to hedge the amount of its
cash offer. If the stockmarket rises sharply and the company is forced to raise the amount of its
bid, it should make sufficient profit on its futures contracts to offset this higher cost.
There are limitations of such a hedging strategy. For example, the share price of the target
company might not move in line with the market index.
Currency futures
To fix the value of receipts
In the same way, currency futures could be used to fix the value of foreign receipts or
payments. In practice, forward currency markets would be used.
Imagine Company XVZ is expecting a payment of $100 million at the end of a year and those
dollars will then be converted back into the domestic currency (eg sterling).
Company XYZ might choose to sell the dollars forward, thereby fixing the value of the receipts in
the domestic currency. For example suppose Company XYZ sells $100 million for £70 million for
settlement in one year's time.
This can be done either as a forward contract or through the exchange in the form of futures
contracts. In either case, the amount of dollars sold is sufficient to hedge the full anticipated
$100 million foreign earnings.
However, suppose the amount of the $100 million US dollar payment is subject to some
uncertainty, eg a large part of the work is cancelled leading to a reduced payment of only $50
million at the end of the year. Company XYZ is now 'over-hedged' because it has a contract to sell
$100 million at the end of the year but now only expects to receive $50 million. It has two
options:
•
If it bought futures contracts then it can close out half of the contracts it bought in the
market. It will reduce the futures exposure until it has a liability to sell only $50 million
dollars in a year's time .
•
If it bought a forward contract then it must settle that contract. Company XYZ would
therefore need to take out a fresh forward contract to buy $50 million for £35 million for
settlement in one year's time. This contract will cancel out half of the existing hedge.
It can be seen that the futures contract gives the company additional flexibility in these
circumstances.
CBl-15: Use of derivatives
f
I
Page9
Question
+ ; f ----------------------------Explain how futures contracts may be useful to bidding companies during pricing negotiations,
when various companies are presenting bids for a large construction project.
Solution
When companies submit bids for construction projects they are exposed to currency and interest
rate movements during the period that the bids are being considered.
Using futures contracts the current market rates can be used to price the bids, and then the
company can hedge its exposure through futures contracts. Even if market rates move during the
bidding process, the company can still be confident that its bid price is sufficient to undertake the
project profitably.
Of course if the bid fails, the company has been exposed to the markets to the extent of the
hedge.
1.4
Forwards
Like futures contracts, forwards are contracts to buy or sell an asset on an agreed basis In
the future. The difference is that futures contracts are standardised contracts that can be
traded In a recognised exchange.
So:
•
a forward contract is a non-standardised and privately negotiated contract between two
parties to trade a specified asset on a set date in the future at a specified price.
•
a futures contract is a standardised, exchange-tradeable contract between two parties to
trade a specified asset on a set date in the future at a specified price.
Some forwards behave a little like futures in that the forward contract might move to a clearing
house immediately after it has been arranged. This is known as 'central clearing' and reduces the
credit risk of the forward for both parties.
Page 10
2
Options
2.1
Introduction
CBl-15: Use of derivatives
Definition
Q An option gives an Investor the right, but not the obllgatlon, to buy or sell a specified asset
-
on a specified future date.
The buyer of an option has the right but not the obligation to take up the option at the specified
exercise price. The seller (writer) of an option has the obligation to honour the option given to
the buyer.
Margins and premiums
The writer of the option pays a margin to the clearing house. The buyer pays a premium to the
writer.
Types of options
Q A cal/ option gives the right, but not the obligation, to buy a specified asset on a set date in
-
the future for a specified price.
A put option gives the right, but not the obligation, to sell a specified asset on a set date in
the future for a specified price.
An American style option is an option that can be exercised on any date before its expiry.
A European style option is an option that can be exercised only at expiry.
Traded options are available on individual equities and also on financial futures contracts.
2.2
Uses of options
We have seen examples of how futures and forwards allow companies to protect themselves
against adverse movements in the financial environment (eg interest rate or exchange rate
changes) by effectively 'locking in' current market rates. However, although futures and forwards
do protect companies from adverse market movements, they also prevent companies from
profiting from favourable movements.
Options allow a company to protect Itself against adverse movements In the financial
environment while retaining the ability to profit from favourable movements.
Since an option is a right to buy (or sell) an asset rather than an obligation to do so, the company
that holds the option can choose to exercise it or not, depending on whether events move in its
favour or move against it. Therefore the option never becomes a liability to the company.
For example, a company that has borrowed at variable interest rates could purchase
options to protect itself against increases in market interest rates. If rates fall the company
will only suffer the loss of the premium paid to purchase the options.
CBl-15: Use of d erivatives
Page 11
t /~
Question
Describe which options would be used in these circumstances.
Solution
The company would buy put options on interest rate futures. These would give it the right to sell
interest rate futures at a fixed price at a fixed date in the future.
If interest rates rise, then the price of the interest rate future would fall, so the company would
exercise its options to sell, thereby making a gain on the future to offset the higher interest rates
it has to pay on its loan.
On the other hand, if interest rates fall (and the price of the future rises) the company will not
exercise its right to sell, and will just benefit from the fall in interest rates on its loan.
Page 12
3
Interest rate and currency swaps
3.1
Introduction
CBl - 15: Use of derivatives
Definition
Q A swap is a contract between two parties under which they agree to exchange a series of
-
payments according to a prearranged formula.
Usually one party to a swap agreement will be a bank (often referred to as the market maker) and
the other will be a company. The bank will enter into many such swaps. The parties involved in a
swap are often called counterparties.
Pricing
The swap will be priced so that the present value of the cashflows is slightly negative for
the investor and positive for the issuing organisation. The difference represents the price
that the investor is prepared to pay for the advantages brought by the swap on the one
hand, and the issuer's expected profit margin on the other.
Risks
Each counterparty to a swap faces two kinds of risk:
Market risk
Q The risk that market conditions will change so that the present value of the net outgo under
-
the agreement increases.
The market maker will often attempt to hedge market risk by entering into an offsetting
agreement.
In other words the market maker would enter into a second agreement, which worked in the
opposite direction, so that the potential loss is cancelled out.
Credit risk
Q The risk that the other counterparty will default on its payments.
-
3.2
This will only occur if the swap has a negative value to the defaulting party so the risk is not
the same as the risk that the counterparty would default on a loan of comparable maturity.
Types of swaps
Interest rate swaps
In the most common form of interest rate swap one party agrees to pay to the other a
regular series of fixed amounts for a certain term. In exchange, the second party agrees to
pay a series of variable amounts based on the level of a short-term interest rate. Both sets
of payments are in the same currency.
CBl-15 : Use of derivatives
Page 13
The fixed payments can be thought of as Interest payments on a deposit at a fixed rate,
while the variable payments are the interest on the same deposit at a floating rate. The
deposit is purely a notional one; no exchange of principal takes place.
For example, a company might agree to a swap where it pays a bank 6% pa fixed for 10 years
based on a nominal amount of £100 million.
•
This would involve making payments of £6 million each year for 10 years to the bank.
•
In return the company would receive interest based on the 6-month money-market
interest rate over the same 10-year period and based on £100 million nominal.
The money-market interest rate will be determined by supply and demand from institutions
wishing to lend and borrow for 6 months and will fluctuate on a daily basis. It will also be affected
by base rates.
.L
I Question
t /r
Suggest why the company may choose to enter into this swap agreement.
Solution
Possible reasons include:
•
It expects the money-market rate to rise over the period such that at the end of the 10-
year period the company will receive more interest than it is paying.
•
It has fixed rate income and variable rate finance outgo over the 10-year period. It can
reduce this investment mismatch risk by making this swap.
3.3
Currency swaps
A currency swap is an agreement to exchange a fixed series of interest payments and a
capital sum In one currency for a fixed series of Interest payments and a capital sum In
another.
A company might agree to pay the current US dollar fixed rate for 10 years based on a nominal
amount of $100 million and receive the current UK fixed rate for 10 years based on a nominal
amount of £60 million. Alternatively it could agree to receive UK floating rate interest on the
basis of the 6-month UK interest rate, re-fixing every 6 months for 10 years. Both of these would
be classed as currency swaps.
The nominal amounts used to calculate the interest payments are different in the two currencies.
One important aspect of currency swaps is that the nominal amount of each position is exchanged
at the end of the contract.
For example, at the expiry of the currency swap described above, the party receiving the US dollar
coupons would receive a payment of $100 million, exactly as if they had bought a 10-year US
bond. They would simultaneously have to pay an amount of £60 million, exactly as if they had
issued a UK sterling bond.
Page 14
3.4
CBl-15: Use of derivatives
Uses of swaps
Risk management
A company can use swaps to reduce risk by matching its assets and liabilities. For example
a company which has short-term liabilities linked to floating interest rates but long-term
fixed rate assets can use Interest rates swaps to achieve a more matched position.
Currency swaps could be used by a company with llablllties In one currency and assets In
another.
·
f1 ;fI Quest1on
A US company is involved in a large overseas project, where an overseas asset will earn profits in
yen for 10 years and then be sold at the end of the 10-year period.
Outline how a currency swap could be used by this company to manage its risk.
Solution
A currency swap would essentially switch all of the yen payments into US dollars at a known
exchange rate. Even if the amounts of the yen profits fluctuate, a swap based on the expected
profits would go a long way to hedge the overall currency risk involved.
At the end of the period the asset will be sold for yen. The exchange of nominal at the end of the
currency swap hedges this final payment as well (albeit in an approximate manner).
A bank might make extensive use of both interest rate swaps and currency swaps.
I Question
t ;r
----------------------------
L
Describe the interest payments that a bank may be making and receivi ng and why these might
lead to the bank making extensive use of interest rate swaps.
Solution
Interest payments that a bank may be making include paying interest on customers' savings;
paying interest to lenders in the money markets who have provided the bank with short-term
finance; and paying interest to bond holders who have provided the bank with long-term finance.
Interest payments that a bank may be receiving include those made by customers, eg individuals
with bank loans or mortgages with the bank and companies with bank loans.
Some of these payments may be at a fixed rate of interest and some at a variable rate, leaving the
bank exposed to changes in variable interest rates. The bank may therefore use interest rate
swaps to better match its interest inflows and outflows and reduce its exposure to this risk.
CBl-15 : Use of derivatives
Page 15
Reducing the cost of debt
If one company has a comparative advantage In borrowing at a floating rate while another
company has a comparative advantage in borrowing at a fixed rate, they can use an interest
rate swap to reduce the total cost of financing and both benefit from a lower cost of debt.
Note that comparative advantage here implies that the companies' relative credit ratings are
different in the long- and short-term debt markets.
Swaps enable companies to borrow at the lowest yield margin (or financial cost) to them . If the
cheapest form of borrowing is not what the company wants, it can swap the payments into the
desired form (ie floating or fixed) using an interest rate swap. Similarly, if the cheapest form of
borrowing is not in the currency the company wants, it can use a currency swap to swap the
payments into the desired currency.
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summaries together for revision purposes.
CBl-15: Use of derivatives
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Chapter 15 Summary
Definitions
A forward contract is a contract to trade an asset at a fixed price at a fixed date in the future.
A future contract is a standardised, tradeable contract to trade an asset at a fixed price at a
fixed date in the future.
A financial future contract is based on an underlying financial instrument rather than a
physical commodity.
An option gives an investor the right, but not the obligation, to buy or sell a specified asset
on a specified future date.
A swap is a contract between two parties under which they agree to exchange a series of
payments according to a prearranged formula.
Uses of derivatives
The uses of derivatives vary widely and can involve:
•
risk management, eg of interest rates, exchange rates, stock market indices or prices
•
borrowing cost reduction.
Companies traditionally use forward contracts for delivery of the raw materials required for
their business. Forward contracts will normally result in deliveries of raw materials to the
buyer of the contract.
Futures contracts on the other hand are used to hedge price movements in commodity
prices or finance costs. These are normally closed before reaching the exercise date.
Options offer companies the ability to hedge downside risk while leaving open the possibility
of upside risk. The cost of this opportunity is the insurance cost of the option premium.
Both interest rate and currency swaps are used by companies primarily to manage their
debt. Companies can reduce risk by structuring their debt to be consistent with their assets.
This can mean swapping fixed into floating rates or vice versa, or indeed swapping a liability
in one currency into one in another currency. Swaps can also enable companies to reduce
the cost of debt.
CBl-15: Use of derivatives
Page 18
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keep the chapter summaries together for revision purposes.
CBl-15: Use of derivatives
Page 19
~~ Chapter 15 Practice Questions
15.1
Exam style
The most likely explanation for an investor buying a call option is that they expect:
A
B
C
D
15.2
Exam style
Margin is:
A
B
C
D
15.3
Exam style
15.4
Exam style
the value of the underlying security to increase.
the value of the underlying security to fall.
interest rates to rise.
a stock market crash.
the cost of buying an option.
the cost of buying a future.
a deposit paid to the seller of a future or writer of an option by the purchaser.
a deposit paid to the clearing house by the buyer and seller of a future and the writer of an
option.
Which of the following strategies would NOT help a company to reduce its exposure to rising
interest rates?
A
B
C
the negotiation of an interest rate swap
the purchase of a put option on an interest rate future
the purchase of a bond future
D
the sale of an interest rate future
Consider both Statement 1 and Statement 2 and decide, for each statement, whether it is true or
false.
If, and only if, you consider both statements to be true, you must decide whether Statement 2 is a
valid explanation as to why Statement 1 is true .
Statement z (Reason)
Statement 1 (Assertion)
In a swap between a bank and
another counterparty, margin is
payable only by the non-bank
counterparty.
A
B
C
D
E
BECAUSE
The bank is the seller of a swap and
cannot be in the position that the
swap is a liability for them and an
asset for the other counterparty.
1 true, 2 true, 2 is a valid explanation to support 1
1 true, 2 true, 2 is NOT a valid explanation to support 1
1 true, 2 false
1 false, 2 true
1 false, 2 false
CBl-15: Use of derivat ives
Page20
The solutions start on the next page so that you can
separate the questions and solutions.
CBl -15: Use of derivatives
Page 21
Ill Chapter 15 Solutions
,....,
15.1
Answer= A
A call option gives the buyer the right to buy the underlying security at a set price. This will be
worth doing if the market price on the expiry date is higher than the exercise price.
If interest rates rise, we might expect the value of shares to fall, so it would not be worth buying a
call option. (It might be worth buying a put option, though.)
15.2
Answer= D
The margin exists to protect the clearing house against credit loss.
15.3
Answer = C
The company could swap a floating interest rate for a fixed interest rate to protect it from rising
interest rates.
By buying a put option on an interest rate future, it is buying the option to sell. It will exercise this
right if interest rates rise.
It would not buy a bond future . If interest rates rise, the price of bonds and therefore of the bond
future will fall. It would make a loss on the future as well as suffering from higher interest rates.
It could sell an interest rate future. If interest rates rise, the price of the interest rate future falls
and thus a profit could be made on the future to offset the rise in interest rates.
15.4
Answer= E
Both counterparties to a swap will potentially have to deposit margin.
This is because either counterparty can be in the position of the swap contract being a liability
depending on how interest rates or exchange rates actually move.
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CBl-16: Growth and restructuring of companies
Page 1
Growth and restructuring of
•
companies
Syllabus objectives
2.5
Corporate growth, restructuring and divestment:
1.
Why companies want to grow larger, how companies achieve internal growth
and the relationship between growth and profitability.
2.
Constraints on a company's growth.
3.
Why a company may wish to divest subsidiaries or business units.
CBl-16: Growth and restructuring of companies
Page2
0
Introduction
In this chapter we look at how and why companies aim to grow in size and grow their profits. We
also consider why a company may wish to divest, ie sell off parts of its business.
Sections 1 to 4 look at the motivations for growth, the links between growth and profits, the
restrictions on growth and the methods of achieving it. Section 5 looks at divesting.
As you work through this chapter, ensure that you keep in mind the plus points of growth, eg :
•
higher sales
•
more control and power of the corporate environment
•
potentially greater profits
while also considering the negative aspects, eg :
•
the expenses of the process
•
agency issues
•
the requirement to raise the finance as debt, cash or as new shares.
Like most things in life, there is a compromise to be made, and many companies that pursue
growth can be very successful, while others grow large only to implode and collapse.
CBl-16: Growth and restructuring of companies
1
Page 3
Motives for growth
Many businesses believe that they need to grow In order to provide a better return for
shareholders, which Is often vital for a company's survival. The motives for growth can
therefore be found In the many ways In which growth can help a company achieve Its overall
aim, including:
1.
Increased profitability.
By Increasing Its output and sales, a business can:
•
benefit from economies of scale
lower average costs, eg by buying in bulk
obtaining better credit terms from suppliers
by investing in machinery and techniques that improve productivity
•
increase its market share and hence its market power (ie its power to
increase prices)
•
expand into new and growing markets.
It can be easier for larger companies to pursue international opportunities, if, for
example many of the fixed overhead costs involved can be absorbed by the
company. If a smaller company aims to expand overseas, the fixed costs would be
a large proportion of the overall profit and might sink the company.
2.
Increased security.
A larger business:
•
can defend itself against an unwelcome takeover bid
•
can overcome barriers to entry in new markets
•
can benefit from risk diversification by expanding the product range,
especially if the present market seems saturated
•
is a greater threat to a potential rival
•
might face lower transactions costs, ie costs of making contracts with other
firms
•
might face less uncertainty and/or is in a better position to cope with
uncertainty
•
will obtain more business as it is seen by customers to be a more reliable
and secure source of supplies.
CBl-16: Growth and restructuring of companies
Page 4
3.
Increased motivation for managers and employees.
A larger business can:
•
provide an environment of increased power, prestige and salary
Many ambitious managers would not join a company that did not offer the
potential for international opportunities.
•
offer decreased employment risk for managers
Managers that have wide-ranging experience are more marketable and find it
easier to get promoted or alternative employment if their current job becomes
insecure.
t .,r
•
result in improved staff morale
•
often attract more able, more ambitious and more productive staff.
Question
List the disadvantages for a financial consultancy firm of growing by aggressive domestic and
overseas expansion.
Solution
1.
A larger company can lose focus, becoming a 'jack of all trades and master of none'.
2.
Management can lose control over parts of the business, leading to inconsistent strategies
being pursued in different parts of the business and different parts of the world.
3.
Regulatory costs and risks can become unmanageable when the firm operates in many
different countries.
4.
Reputational issues may impact performance not just in one country but on the entire
brand.
5.
The company may lose its domestic 'brand' and be seen as just another global utility.
6.
The company will be exposed to political measures taken in overseas countries, such as
trade barriers, prohibiting the repatriation of profits, exchange rate controls and
employment restrictions and controls.
There may be many more that you thought about that are not included on this list.
CBl-16: Growth and restructuring of companies
2
Page 5
The relationship between profit and growth
Profits fund a large proportion of new Investment so, In order to grow, the company needs
profits. Even If the company Is able to obtain some long-term finance, It will probably have
to finance some of Its growth by ploughing back some of Its profits (ie retaining profit rather
than distributing It as dividends to the shareholders).
However, undertaking a growth strategy can be very expensive for the company.
In the short term, as well as the Investment In plant and equipment, there will be additional
expenses, such as advertising and training costs, which could reduce annual profit.
In the longer run, as the new investment brings results in the form of higher revenue and
lower costs, annual profit should increase.
A growing company will run out of office space for its staff and need bigger premises. It may also
need more manufacturing facilities, and more plant & machinery to cope with the higher
demands. These all require finance, which needs to come either from retained profits, or by
raising new finance in the form of debt or equity.
f I Question
+ / r -----------------------------lf a company has a payout ratio of 0.5 (or a dividend cover of 2), suggest what this indicates about
the finance it will have available to plough back into the business.
Solution
At first glance it looks like the company is paying a half of its profits as dividends, which means
that the other half should be available for financing growth in each year.
However, profits do not mean cash. For example, if a company retains half of its profits in a
particular year when a bank loan is maturing and requires to be repaid, the company may in fact
be cash negative in that year which will mean there is no ca sh for growth.
CBl-16: Growth and restructuring of companies
Page6
The constraints on growth
3
The firm's plans for growth can be constrained for a number of reasons:
•
Difficulties In raising finance.
Potential Investors (shareholders, venture capitalists, creditors) will consider the
expected outlook for the economy In general, and the firm's Investment plans, Its
reputation and Its creditworthiness.
Venture capitalists are investors that specialise in financing smaller or riskier ventures.
Venture capital is usually provided by specialist companies that have skills in analysing the
prospects for small companies that would not manage to raise finance on the main
stockmarket.
•
Fears of a fall in the share price.
If a firm does not have the confidence of Its shareholders, a fall In dividends
because of profit being Invested in the business might cause shareholders to sell
their shares.
The resulting fall in the share price might lead to an unwelcome takeover bid. The
lower the valuation ratio (or price to book ratio), which measures the ratio of the
stock market value to the book value of the firm, the more vulnerable the firm.
•
Lack of managerial experience and expertise.
Running a large business is more complex, more time-consuming and more
expensive than running a small business. It requires skilled managers, clear
management structures and delegation.
Some owner/managers of small businesses may be reluctant to lose direct control
and might resist growth or manage it badly.
•
Limited time to prepare the workforce including management.
•
Government policy on monopoly power and mergers.
Governments may wish to prevent takeovers on the grounds of national security or
monopoly, when a domestic company is purchased by an overseas competitor. The
competitor may not have the same loyalty to the country so may move jobs/head office
functions overseas for efficiency.
However it may be impossible to prevent takeovers, or even to try to prevent them as to
do so may breach international trade rules.
f
~ Question
t /J
List the groups of institutions or individuals that might be labelled as 'creditors'.
CBl-16: Growth and restructuring of companies
Page7
Solution
•
Banks, either retail (which finance smaller companies) or wholesale (which finance larger
ventures)
•
Bond investors
•
Venture capitalists (who usually prefer equity finance, but may also provide debt)
•
Peer-to-peer lending organisations
•
Suppliers who may grant trade credit or offer credit sale options
t /~
Question
Suggest other investment ratios that shareholders and competitors may look at that would be
affected by a fall in the share price.
Solution
In addition to the 'price to book', shareholders also look at:
•
. ,e
. -price
share
. f aII s, t h'1s ratio
. w1·11 f aII, ma k'mg t he company
PE ratio,
- -per
-- - . If t he price
earnings per share
look cheap to a competitor, who may decide to launch a takeover.
•
. Id, ,e
. dividend
. f aII s, an d t he y1e
. Id rises,
.
. per share . If t he price
t he company
D.1v1'den d y1e
pnce per share
seems an attractive investment.
CBl-16: Growth and restructuring of companies
Pages
4
Methods of achieving growth
There are many methods of achieving growth, but they can be divided into two main groups:
1.
internal (or organic) growth, ie expansion of its own operations
2.
external growth, ie Integration with another firm or firms.
Internal growth
Internal growth might be preferred by firms that wish to:
t .,r
•
retain control
•
avoid the disruptive influence of alien business cultures or practices
•
avoid the risk of dealing with firms that lack integrity
•
avoid unnecessary government intervention.
Question
Explain how internal growth 'retains control'.
Solution
Internal growth means that management can retain control of decisions, such as location, range
of products and strategy, because the company is deciding where the growth should take place.
This contrasts with external growth which might involve taking over an existing company, and
accepting the business mix of the target company, and bringing some of the managers of the
target company into the new expanded company.
Internal growth is also financed by retained profits, debt issues, or share issues to existing
shareholders. In these circumstances, voting control of the company does not necessarily change.
External growth may involve merging with another company, usually by offering new shares in the
company to the existing shareholders of a target company. These shareholders will then have
voting influence in the new expanded company, and so the control has diluted.
CBl-16: Growth and restructuring of companies
Page 9
External growth
On the other hand, external growth might offer:
•
an easier and quicker method of growth, especially If the company wishes to expand
geographically
the opportunity to acquire assets or experience
•
the opportunity to share the financial burden and the risk of a project
•
the opportunity of a good use of spare cash for a mature company.
In many circumstances, mature companies in mature industries generate lots of profit,
but may have few growth opportunities. Shareholders do not really want all profits paid
back in the form of dividends, therefore external growth is an essential strategy.
.L
I Question
t /( ------------------------------Explain why it might be a bad idea for a food manufacturer to use its spare cash to expand into
the car manufacturing industry.
Solution
The company has no experience in the car manufacturing business, and is highly likely to make a
mess of it! A lack of expertise and so weak strategy in an already competitive industry is
ultimately likely to fail, making losses for shareholders.
Secondly, shareholders that buy shares in the food manufacturer are probably looking to invest in
a relatively safe, stable industry. If the business slowly becomes a mixture of food and car
manufacturing, it will become much riskier and more cyclical. This may not suit the original
investors, who will sell the shares and invest elsewhere.
4.1
Methods of internal growth
Internal growth occurs when a business expands its own operations rather than by
operating with other business. This can be achieved in three ways. A firm can expand:
•
by horizontal expansion, ie by increasing production of goods or services at the
same stage of the production process, eg a food manufacturer
•
by vertical expansion, ie by developing new operations at a different stage of the in
the production process, eg a food manufacturer might move backwards into farming
or forwards into retailing
•
by diversification, ie by moving Into completely different markets, eg a mall-order
business might expand Into radio stations, trains, airlines and banking.
Diversifying expansion projects are often supported by management, because the
diversified profits may make the company less exposed to the downturn in one industry.
A more stable employer is seen by management as a good thing.
CBl-16 : Growth and restructuring of companies
Page 10
However, a diversified company can be a lot less dynamic than one pursuing a strategy in
one field, and the long-term growth can be poor as a result. This is generally bad for
shareholders, even if it makes managers feel more comfortable. The shareholders do not
derive the same diversification benefit as the managers, as shareholders can already
diversify their shareholdings between different companies and markets.
4.2
Methods of external growth
External growth occurs when a firm merges with, takes over or works Jointly with another
firm or firms.
This integration can take the same three forms as above:
!
.1. -
•
horizontal integration involves two or more firms at the same stage of the production
process in the same industry and aims to increase the size of business, eg two car
manufacturers
•
vertical integration involves two or more firms at different stages of the same
production process In the same Industry and alms to strengthen the supply chain,
eg a car manufacturer and a supplier of car components, or a car manufacturer and a
car retailer
•
conglomerate integration involves two or more firms in completely different
industries, eg a car manufacturer and a hotel chain.
I~ Quest1on
.
~
It is often claimed that giant companies such as Apple, Facebook, Microsoft, Twitter, etc, have so
much cash and power that they acquire every startup or medium-sized business in their field.
This level of horizontal expansion is deemed to be good for shareholders as it means that the
company is at the forefront of technological advance, and is always in touch with the direction of
travel in the fast-changing internet/social media world .
Suggest possible negatives of such a strategy of aggressive horizontal expansion.
Solution
Excessive power in an industry comes at the risk of excessive control and dominance.
It can become impossible for other companies to compete and therefore the industry can become
monopolistic. This can become negative in the longer term.
In addition, the management of these companies may find it hard to continually merge several
hundred new companies into the existing business every year.
Culture, technological and management changes can mean that the new expansion investments
fail to reach their true potential (ie the potential that they had as stand-alone businesses).
Large companies sometimes buy start-up companies simply to close them down.
CBl-16 : Growth and restructuring of companies
5
Page 11
Motives for divesting
Companies cannot continue growing forever and they may, indeed, shrink or change their
business plans thus divesting subsidiaries or units of the business.
5.1
•
This may be done because the relevant business unit is not earning a sufficient
return on the equity needed to support it.
•
It may be because a potential buyer for a business unit may value It more highly
than the existing owner (perhaps because the potential buyer will manage it more
effectively or be able to gain better synergies with the rest of Its business).
•
A company might wish to divest units because it wishes to change its strategy
(either In relation to the focus of the business or In terms of Its International
Interests).
•
Trading In some countries might also become unprofitable or difficult for political
reasons.
Examples
Perhaps some of these points are best illustrated by two hypothetical examples.
1.
A health insurance company in a given country has a globally diversified business
model but with a focus on Europe. Its European business is declining as a result of
demographic factors and there are a number of Asian countries in which it has no
presence. It has found that its return on equity and market size in Europe has fallen
below an acceptable level and there is no prospect of it increasing.
It decides to sell the majority of its European business to another health insurer
which can obtain greater economies of scale and to use the capital to develop
operations in further Asian countries.
2.
An insurance company sells a variety of life and annuity business and has always
had its own Investment management subsidiary. It has sold a limited amount of unit
trust business. However, it now finds that all its life business is best matched by
portfolios of government and corporate bonds and thus does not need a general
investment management operation. The rate of return on the capital invested in the
investment management subsidiary has fallen.
It decides to close the subsidiary whilst selling the unit trust business to a specialist
fund management company.
An example of a significant divestment is the sale by Lloyds of the TSB business and a
large number of branches, though this was an action required as a result of decisions by
the European Union rather than being a business decision. Another example, outside the
financial sector, is the sale by Whitbread, a hotel and restaurant group, of the Costa Coffee
chain to Coca Cola.
~
I Question
f ; f --------------------------------Suggest likely motives for Whitbread's sale of Costa Coffee.
Page 12
CBl-16: Growth and restructuring of companies
Solution
Whitbread could have narrowed its strategy to focus more on its hotel business. The proceeds
from the sale of Costa Coffee may give it cash to enable it to invest in its hotel brands and expand
its number of hotels.
The price offered by Coca Cola may have exceeded Whitbread's valuation of Costa Coffee if the
synergies to Coca Cola {eg diversifying and achieving economies of scale within the drinks sector)
were greater than those available to Whitbread.
CBl-16: Growth and restructuring of companies
Page 13
Chapter 16 Summary
Motives for growth
The main motives are:
•
to increase profitability benefiting from economies of scale, increasing market share
and expansion into new and growing markets
•
to increase security in terms of threat to and from other companies, barriers to
entry, diversification, lower transaction costs, volatility, reputation
•
motivation for employees and managers in terms of power, prestige, salary, stability
of employment, ambition and morale.
Growth is a trade-off between these benefits and the costs of the expansion.
Constraints on growth
•
Availability of finance
•
Effect on the share price if cash is diverted from dividends
•
Lack of management experience
•
Limited time to prepare the workforce and management for changes
•
Government policy on monopoly power and mergers
Methods of achieving growth
Internal growth involves expansion of existing facilities and production. Advantages:
•
retain control
•
avoid the disruptive influence of alien business cultures or practices
•
avoid the risk of dealing with firms that lack integrity
•
avoid unnecessary government intervention.
External growth involves buying existing facilities through takeover or merger. Advantages:
•
an easier and quicker method of growth, especially if wish to expand geographically
•
the opportunity to acquire assets or experience
•
the opportunity to share the financial burden and the risk of a project
•
the opportunity of a good use of spare cash for a mature company.
Most growth can be classed as:
•
horizontal ie the same stage in the production cycle
•
vertical ie different stages in the production process
•
conglomerate or diversification ie taking over a company in a different industry or
expanding into a completely different industry.
Page 14
CBl-16: Growth and restructuring of companies
Motives for divesting
The main motives are:
•
a business unit not earning a sufficient return on equity
•
a potential buyer valuing a business unit more highly than the current owner
•
a change in strategy, eg in focus of business areas or locations
•
trading in some countries becoming unprofitable or difficult for political reasons.
CBl-16 : Growth and restructuring of companies
Page 15
~~ Chapter 16 Practice Questions
16.1
Exam style
16.2
Which of the following is NOT an advantage for a company that uses mainly internal growth to
expand its operations?
A
It is easier and quicker when the company wants to expand geographically.
B
C
D
It ensures that shareholders retain control of the company.
It avoids government intervention.
It avoids the disruption of dealing with alien business cultures and practices.
Match each of these potential takeovers with the most likely motivation for the acquisition.
Exam style
II
Ill
IV
A restaurant chain may acquire an organic meat supplier .. .
A travel chain may acquire another travel chain ...
A travel chain may acquire a fashion clothing chain ...
A bank may acquire a general insurance company ...
A
B
C
D
... to reduce risk by expanding into a different industry.
... to increase profits by expanding the product range it can provide to current customers.
... to reduce risk by gaining greater control over its supply chain.
... to increase profits by increasing its market power to set prices.
Page 16
CBl-16: Growth and restructuring of companies
The solutions start on the next page so that you can
separate the questions and solutions.
CBl-16: Growth and restructuring of companies
Page 17
•
Chapter 16 Solutions
r--,
16.1
Answer= A
Quickly expanding geographically is an advantage for a company that uses external growth to
expand its operations.
16.2
I - C, II - D, Ill -A, IV - B
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CBl- 17: WACC
Page 1
Weighted average cost of capital
Syllabus objectives
2.4
Factors a company should consider when deciding on its capital structure and
dividend policy:
1.
Impact of a chosen capital structure on the market valuation of the
company.
(Covered in part in this chapter.)
3.1
Interaction of the cost of capital of a company with the nature of the investment
projects it undertakes:
1.
A company's cost of capital.
2.
The calculation of a company's weighted average cost of capital.
Page2
0
CBl-17: WACC
Introduction
In this chapter we consider the weighted average cost of capital, which is important and helpful
for the management of a company in appraising different capital projects.
The weighted average cost of capital (WACC) is the average cost of raising finance for the
business, allowing for both debt and equity capital. It can be used as the discount rate in net
present value calculations and so it is relevant to the investment decision.
The later parts of this chapter use the capital asset pricing model (CAPM) to estimate the cost of
equity capital. Most of the formulae in this chapter rely on the results of the CAPM.
The examination could test, for example, the ability to calculate a WACC and the ability to assess
the effect of factors such as gearing and tax on the WACC.
CBl-17: WACC
Page3
1
Overview
1.1
The importance of the weighted average cost of capital
The role of the financial manager is to raise finance through an appropriate blend of debt and
equity (the financing decision) and to use the funds to invest in suitable projects (the investment
decision). The goal of the financial manager is to maximise shareholder wealth. They achieve this
by investing in profitable projects.
It is now generally accepted that discounted cashflow techniques for evaluating projects are
far superior to the use of simple payback approaches or accounting rates of return. The
shareholder value-added approach enhances these techniques further.
However, to use these techniques requires the calculation of the project cost of capital. In
the absence of a suitable discount rate, NPV and IRR approaches have no meaning.
Provided that the project achieves the expected return and that, when adjusted for the risk
of that project, the return is more than the company's weighted average cost of capital
(WACC), the shareholders are better off than before.
So, in order to choose appropriate projects, the company must know its WACC since this will
usually (but not always) be used as the discount rate in the project appraisal process.
In this chapter, we are going to find out what determines the WACC. In particular, how the
financing decision (ie the debt/equity balance) affects the cost of capital and the link between the
financing decision and the investment decision.
1.2
Defining the weighted average cost of capital
Although there are many methods of financing a company, they broadly fall into just the two
camps of equity or debt.
The WACC is defined as follows:
Market value of debt
,Fd b
WACC = - - - - - - - - - - x netcosto1 e t
Market value of debt+ equity
Market value of equity
,F
.
+ - - - - - - - - - - x costo1 equ,ty
Market value of debt+equity
Here we are dealing with the market value of the equity and debt rather than the book or
accounting value, although book values may need to be used where market values are not
available.
Remember that the cost of equity is the total return to individuals who invest in the shares, not
simply the dividend yield, ie the cost of equity needs to allow for capital gain too.
Page4
CBl-17 : WACC
'Gearing' was defined earlier in the course as:
book value of debt
book value of debt
or
book value of debt + book value of equity
book value of equity
where the book value of the equity is the accounting value of the share capital plus all equity
reserves (such as revaluation, retained earnings, etc).
In this chapter we usually deal with market values. Thus 'gearing' could also be defined as:
market value of debt
market value of debt
or
market value of debt + market value of equity
market value of equity
where the market value of the equities and debt (bonds) would be the number of each issued
multiplied by the market price of each.
The cost of debt and the cost of equity
It is the net cost of debt that appears in the WACC formula, where:
net cost of debt= gross cost of debt x (1- t)
where t is the rate of corporation tax.
Interest payments on debt finance are tax deductible. They appear before the tax line on the
statement of profit or loss.
All of these formulae appear in the Core Reading as we progress through this chapter.
The cost of equity, which is discussed further below, will tend to be higher than the cost of
debt In part due to the more favourable tax treatment of debt. This has led to debate over
the correct cost of capital to use because the weighted average cost of capital (WACC) will
be very sensitive to the ratio of debt to equity on a company's balance sheet.
.!.J. t
~I Question
/ 1--------------------------------
A company' s dividend yield is 3% pa and the gross redemption yield on its debt is 6% pa. Discuss
the expected rate of return for an equi ty investor and the rate of return for a bond investor.
Solution
The rate of return for a bond investor is relatively clear; it is the redemption yield on the bond,
namely 6% pa.
The expected return for equity investors can't be determined from the information given, as this
is equal to dividend yield plus capital growth.
The equity shareholders are accepting a greater risk than the bond investors, and must therefore
be expecting a return greater than 6% pa. This greater return must be expected in the form of
capital growth through retained earnings and increasing dividends.
Pages
CBl- 17 : WACC
The term 'cost of equity' is the return that the managers of the company have to provide to keep
equity shareholders happy, and in a fair world is equal to the expected return on equity.
Example
Suppose that Growmore pie has:
•
debt with a market value of £100m trading at a gross redemption yield (GRY) of 5% pa in
the market
•
£100m market value of equity with analysis suggesting equity investors expecting 10% pa
from their investment.
Growmore's weighted cost of capital, assuming no tax is paid, is 7.5% pa (ie weighted average of
the cost of equity and the gross cost of debt). If the company can earn 7.5% pa return on its
assets, it can give a 5% pa return to the loan capital providers and a 10% pa return to the equity
capital providers.
This is the essence of a weighted cost of capital calculation.
1.3
Theoretical background
The traditional view
In the traditional school the emphasis was on determining the amount of debt a company
could safely carry without risking bankruptcy In a severe recession.
Debt is cheaper than equity finance, so as gearing increases, the WACC should fall.
However, increasing the proportion of debt finance increases the risk to shareholders so
shareholders demand a greater return for this increased risk.
Therefore beyond a certain level of gearing, the downward effect on the WACC of increasing the
debt finance in the business will be more than offset by the increase in the return required by
shareholders. In this case the graph of the WACC against gearing would be U-shaped.
WACC (%)
C*
G*
Gearing
CBl-17: WACC
Page6
The WACC is lowest at C* when gearing is at G*.
This is potentially very important. It means that changing the capital structure could change the
profitability of investment projects and result in a change in the value of the company.
Modigliani and Miller
In the late 1950s and early 1960s the traditional school was attacked by Modigliani and
MIiier (MM) who held that gearing was Irrelevant and that each Increase In debt carried a
compensating increase in the cost of the equity.
A key concept in corporate finance is expressed in Modigliani and Miller's first irrelevance
proposition:
1.
The market value of any firm is independent of its capital structure.
This is the basis of Modigliani and Miller's second irrelevance proposition:
2.
The expected rate of return on the common stock of a leveraged firm increases in
proportion to the debt-equity ratio, expressed in market values.
Leverage is the term used in the US for gearing, so a leveraged firm is a geared firm, ie one that
has some debt finance. Common stock refers to the company's ordinary shares.
Modigliani and Miller argued that, under certain assumptions, gearing has no effect on the value
of the company. Their view was that the value of the company lies in its ability to produce profits,
not in the way that it is financed - in other words, that the market value of a company is
determined primarily by its investment decisions and not by its financing decisions . This
proposition allows complete separation of investment and financing decisions.
They began with a simple model with the following assumptions:
•
there are no taxes
•
unlimited personal and company borrowing is possible at the same rate of interest
•
debt is risk-free
•
there are no agency costs
•
there are no information asymmetries.
The arguments in the MM model revolve around the concept of risk and return. When a
company is financed by equity alone, the shareholders only face business risk. As debt increases
in the business, shareholders face increased financial risk as returns become more volatile.
If there are two companies with the same business risk and the same annual earnings but with
different capital structures and different market values, then by exploiting arbitrage possibilities,
the values of the two companies will (according to MM) become equal.
f
~ Question
t ;,
Explain what is meant by 'exploiting arbitrage possibilities'.
Page 7
CBl-17: WACC
Solution
Arbitrage is the buying and selling of financial assets in order to make a risk-free profit from
known pricing anomalies.
The MM model predicts that for companies with the same business risk and the same earnings,
the WACC is the same, regardless of gearing.
Let us now consider the effect of gearing on the return on equity.
The following graph shows the rates of return on debt and equity for a single company as its
gearing ratio increases.
Rate of return (%)
· ··· .-~:_'.'.°.'.:~~~---· · ---·· ::::--·· · .
Cost of debt
Gearing
Modigliani and Miller argued that the WACC remains constant as gearing increases. As gearing
increases, the cost of equity increases by just enough to offset the increasing proportion of the
cheaper debt.
A more highly geared structure offers a higher return on equity, but it also offers a higher risk.
These two features cancel out to leave the price of the shares, the value of the company and the
WACC unchanged.
Additionally we can argue (under the assumptions of the simple model) that increasing the
gearing within a company only gives the shareholders the same increase in returns that they
could have achieved themselves by borrowing money from a bank and buying more shares. So
gearing up a company adds no value, because shareholders can increase their own risk by
borrowing money from a bank and buying more shares.
This thinking was further developed by the Capital Asset Pricing Model (CAPM) which
attempts to provide a coherent framework for understanding the interaction of risk and
return.
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f ;f Question
Suppose Growmore pie (from page 5} raises a further £50 million of debt finance in order to buy
back shares with a value of £50 million.
Explain the impact on Growmore's WACC.
Solution
The obvious conclusion would be that the weighted cost of capital would fall, because the
company is now financed by £150 million of 5% debt and £50 million of 10% equity.
However, according to MM, this argument is flawed because the required return of equity
investors would not remain constant if the company structure were changed in this way.
The company is now much more highly geared and the returns to equity investors are likely to be
much more volatile. In fact so much more, that the equity investors will require a return of 15%
in order to hold the shares.
According to MM, the cost of capital is unchanged, being a mixture of £150 million of debt capital
providers requiring 5% pa and £50 million of equity capital providers requiring a return of 15% pa,
the weighted average of which is 7.5% pa .
Later theories
The MM theorems are a cornerstone of finance. The subsequent development of the theory of
corporate finance can be described essentially as exploring the consequences of relaxing the
strong MM assumptions.
The effect of tax
Interest payments on corporate debt are tax deductible, so debt finance for firms is treated more
favourably by the tax system than equity finance, thus making debt finance more attractive.
Whilst the original MM paper argued that the cost of capital should not be dependent on the
level of gearing adopted by the company, they subsequently developed an after-tax
formulation.
The after-tax version examined the tax advantages of debt finance. Whereas the initial model
suggested that the value of the pie is independent of how the pie is split (between debt and
equity}, the introduction of tax implies that there is a third slice, ie the government's slice.
The tax system provides a debt tax shield (ie a reduction in tax) so that the value of the geared
firm is the value of the ungeared firm plus the tax shield. This could suggest that firms should
become 100% debt financed if we ignore other considerations!
However, MM later found that when personal income taxes as well as corporate taxes are taken
into account, the gain from a company increasing its gearing is reduced, eliminated or even
negative.
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CBl-17 : WACC
The effect of different borrowing rates
If we allow for companies being able to borrow at lower rates of interest than individuals, then it
means that individuals would not be able to replicate the returns from a more highly geared
company by borrowing and buying more shares themselves (as MM assumed).
Firms that borrow could be seen as performing a valuable function for their investors. (This point
is enhanced by the fact that companies receive tax relief on the ir borrowings but individuals do
not.)
Also, corporate bond yields (ie the cost of debt) tend to vary inversely with the size of the firm .
This implies that the WACC would decrease with increased gearing, particularly for large firms.
The effect of restricted debt capacity
The MM analysis assumed that increased debt can be raised at the same cost as before, but of
course the debt is not risk-free. Loan capital providers would reassess the required return on the
company's debt given the new, more highly geared and risky structure, ie the credit rating of the
company would decrease.
ffi)} Question
Suppose Growmore pie' s existing and new debt are likely to trade on a level of (say) 6% GRY to
compensate for the higher risk of default attaching to the company's debt. The equity holders
have also increased their required return (to 15%) to reflect the greater risk of default and the
greater volatility of the highly geared company. Determine the new WACC.
Solution
The cost of capital for the company would now be:
WACC= 150 x 6%+ 50 x 15% =S. 2S%
200
ie higher than before!
Therefore, in practice, an increase in gearing, beyond the company's debt capacity, could increase
the company' s WACC.
Conclusion
Putting the above arguments together suggest s that increasing the level of debt in the business
will initially reduce the WACC as the company takes advantage of the lower cost of debt and the
tax relief on debt finance.
However, as debt finance increases, both equity holders and debt holders will require a higher
rate of return. There will be a point at which the costs of increasing the gearing begin to
outweigh the benefits and the WACC begins to increase, ie there will be an optimal capital
structure.
Page 10
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WACC (%)
Minimum
cost
of capital
Optimal capital
structure
Gearing
However, there is no simple golden rule: the optimum capital structure varies from firm to firm
and from industry to industry. We shall study capital structure in more detail in the next chapter.
We shall now study the cost of equity and the cost of debt separately in the next two sections and
subsequently put them together to look at the WACC.
CBl-17: WACC
2
Cost of equity
2.1
Introduction
Page 11
The cost of equity represents the opportunity cost of capital - the rate foregone by
shareholders investing in the project rather than investing in alternative securities.
Risk and return
It seems reasonable that the market should reward the additional risk being taken by the
equity holders. (There are investors who enjoy the gamble and opportunity to make money
by beating the odds so there Is no guarantee that all prefer a steady return and price to a
volatile one.)
What is certain is that there are many investors who are effectively excluded from
investment in equities because they cannot afford much in the way of a downside potential.
So one would expect a premium on equities due to supply and demand considerations.
f /~
Question
Discuss the validity of the following statement:
'Many investors shy away from equity investment because the risks involved are too high,
therefore the expected return from equities is higher than that from debt.'
Solution
This statement is correct.
If an investment in equities is more risky than an investment in bonds, but offers the same
expected return, then rational investors will not buy equities. If investors do not buy equities the
prices will fall. Eventually, at much lower prices, equity investments will offer a much better
prospect, and a higher expected return (ie they become 'cheaper').
At this level the equity and bond markets are in equilibrium, offering a trade-off between risk and
return.
Formula
The conventional approach to the cost of equity Is to state It as :
Cost of Equity = Risk-free rate + Equity risk premium
The risk-free rate can be regarded as the return required from a risk-free asset such as a
government bond. (Government bonds are often known as gilt-edged securities or gilts.)
The equity risk premium is the additional reward required by equity holders to cover the additional
risk of holding shares rather than risk-free bonds. Later in the chapter we look at a more
sophisticated version of this formula that adds a different risk premium for different types of equity
investment, according to the risks involved.
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Evidence
An obvious starting point would be to look back at historic rates of return on securities.
In practice it is usual to use market indices, or bundles of representative securities, for this
purpose.
Choice of the historical period
It is a matter of record that equities have performed better than fixed-interest investments
over any sufficiently long-term period. This is true of many stock markets worldwide.
However, there is considerable volatility in price levels and on an inflation-adjusted basis
there have been occasions where if one bought at a peak, it has taken 15 years for the
equity portfolio to have got back to the same position.
In respect of past performance, most commentators would suggest that data taken from as
long a period as possible should be used, provided that it is adequately homogenous.
Clearly, if the nature of the constituents within the portfolio being analysed have changed
substantially, then some sub-set of the data might be more appropriate.
It may be possible to enhance the data available by using results taken more frequently, eg
monthly rather than annual returns.
However, it Is important to interpret such data with care in order to eliminate explicit bias
(such as seasonal elements) as well as statistical factors (such as the measure of volatility).
Real and nominal rates
One source of heterogeneity can be removed if real, rather than nominal, rates are analysed,
while the risk-free rate can be defined on a nominal basis (In which case one might use a
conventional fixed-interest gilt rate of a term similar in length to the project), alternatively
one can work using real returns, in which case the yield on Index-linked gilts can be used.
However, removing the actual inflation experienced will not address the Issue of the
inflation risk premium contained in the rates observed.
Remember that the inflation risk premium is the additional return required by investors as
compensation for an uncertain inflation rate.
For this reason, it is probably more appropriate to decompose the historical data into two
parts:
•
the risk-free rate - usually taken as the return on Treasury BIiis or other short-term
government loans
•
the risk premium - the additional return provided by the security or index under
consideration.
By establishing the average risk premium from historic data, we can estimate the future
required opportunity cost as being the current (or expected) risk-free rate plus the expected
(average) risk premium.
Even so, many practitioners would adjust the risk premium to reflect their views about the
relevance of past experience to future conditions.
CBl-1 7: WACC
Page 13
Clearly, the choice of a real, rather than a nominal, rate will need to be reflected in the
nature of the cashflows projected for discounting. Real cashflows should be discounted at
a real rate of return, while nominal cashflows will need a nominal rate for discounting.
We shall assume here that we are concerned with the determination of a real discount rate
which is to be used in conjunction with cashflows determined on the basis of present day
money values excluding the effects of future price inflation.
For some purposes, however, notably when the financing of the project is being considered,
it may be more appropriate to allow for future price inflation in the cashflows and (where
appropriate) in the financing payments.
In this case a nominal discount rate equal to the real rate compounded with the assumed
average rate of price inflation should be used. This may give a different result if some of the
cashflows would not increase with price inflation.
Typical results
One of the most accessible studies in the UK is the Barclays Equity Gilt study. Looking at
dividend yield and growth, this study calculates the historic return on equity as 5% real.
Assuming a risk-free real rate of 1.5-3%, this suggests an equity risk premium of 2-3.5%.
The calculation of 5% referred to above is based on a period from 1899 to the present and it
effectively looks at the growth of an index assuming reinvestment of dividends over that
period and adjusted for inflation.
If one simply calculates the average return, investing £1 each year and averaging the result,
then the apparent return of equities would be higher.
The reason for this is a direct result of the volatility of equities as in an index fund if the
market halves then only half the amount is available for investment the following year.
Mathematically, the long-term index return is like a geometric mean and the average annual
return like an arithmetic mean. The arithmetic mean will always be greater than the
geometric mean.
This discussion is very technical, but is not intended to cause concern. In particular, it is not
intending to test understanding of the difference between arithmetic and geometric means, but
to illustrate the dangers of spurious accuracy.
This discussion is to warn against any attempt for extreme accuracy where risk and
uncertainty are involved. It is more important to grasp the principles than to follow a
mathematical formula.
Ultimately, the discount rate we use will only need to be roughly right as its main purpose is
to help rank projects and not to price them exactly. As in all actuarial work, it will be
consistency of approach and application of judgement that are of prime importance.
2.2
The capital asset pricing model (CAPM) and risk
Risk and volatility
Next it is necessary to compare the individual company and the market indices from which
the historic returns were computed.
We need to find the cost of equity for a particular company.
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CBl-17: WACC
This cost comprises the two parts: the risk-free return and the equity risk premium for this
particular company.
We want to find out what return the shareholders of a particular company require. This will be
related to the risk they perceive in the company's shares.
A market portfolio of equities suffers a relatively high degree of volatility. The standard
deviation of annual returns of the UK stock market on a real basis Is around 20%.
It is equally clear from one day's observation of the stock market that not all shares move in
the same direction at the same time and to the same degree.
As Is well known, diversification reduces risk.
Specifically, the variance (or standard deviation) of the returns experienced by individual
stocks are different to (and usually greater than) the market as a whole. This is a
consequence of the fact that the individual stock returns are, typically, not perfectly
correlated.
Thus the portfolio variance is given by:
LL x,xJPf}UfUJ
f
J
where x;, x 1 are the proportions of stock i and j held, u; and u 1 are the standard
deviations of stock returns and P;J is the correlation coefficient between the returns on
stocks i and j.
This formula gives the variance of a sum of correlated random variables.
This begs the question as to what the performance volatility of an individual share is
compared to the market average.
The CAPM provides a coherent theoretical framework for examining this issue.
The CAPM is only valid within a special set of assumptions. These include the following:
•
investors are rational (they aim to maximise expected satisfaction)
•
investors are risk-averse (they would reject a fair gamble)
•
investors can borrow or lend unlimited amounts of a risk-free asset at the constant riskfree rate
•
the market is efficient (lots of buyers and sellers, perfect information etc)
•
the volatility of returns is a good measure of risk.
Although these (and other) assumptions are rarely met, CAPM is one of the most frequently used
models of risk and return.
The CAPM divides the volatility of a stock's price Into two parts, the specific risk and the
systematic risk.
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Page 15
Specific risk
The concept of specific risk can be demonstrated using examples:
•
A company in the business of property development on brownfield sites is exposed to
problems such as labour shortages, environmental problems and poor project
management.
•
A retailer might face the risk of damage to the company's reputation if its products are
endorsed by a famous personality who becomes the subject of some scandal.
The CAPM theory assumes that all shareholders hold a large, well-diversified portfolio of shares.
Certain companies might suffer from these downside specific risks while other companies may be
unaffected, and other companies may be affected positively (eg the retailer's competitors).
The specific risk of a portfolio of shares reduces rapidly as the number of shares in a portfolio
increases from one to two to three, etc. Eventually by the law of large numbers, the specific risk
in the portfolio is diversified away.
Q Specific risk is risk that can be eliminated by diversification.
-
Shareholders who hold a diverse portfolio of shares will not therefore be concerned about
earning a return to compensate for a company's specific risk.
Systematic risk
If shareholders hold a fully diversified portfolio of shares, they can remove all of the specific risk.
However each company is still exposed to a high degree of systematic risk.
Systematic risk would be the risk of being exposed to the economy in general.
Many events can affect the market as a whole, such as movements in interest rates, inflation or
currency fluctuations, and cannot be diversified away by having many shares. These events will
influence the success of all of the companies .
.
Q Systematic risk or market risk cannot be diversified away.
i
-
I Question
t / f - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -The following business deal is being offered:
Throw a fair die a specified number of times (the number of throws is subject to negotiation).
Receive (or pay if negative) the difference between 4 and the average score, x, ie ( 4-x) times
one dollar for each throw of the dice.
Describe the specific risk if the project involves throwing the die:
(a)
three times
(b)
one million times.
Page 16
CBl-17: WACC
Solution
If only three throws of the die are made there is a specific risk that the project may yield a loss.
This is a specific risk though, and could be diversified away if many such projects were undertaken
{or if the die is thrown many times).
The law of large numbers guarantees that ultimately the thrower will achieve an average score of
3.5 and an average profit of $0.50 per throw.
In theory, the specific risk can be diversified away on a large well-spread portfolio leaving
the systematic risk, which is the volatility of the individual share compared to the market as
a whole which cannot be eliminated by diversification.
Shareholders who hold a diversified portfolio of shares and are considering buying a particular
company's shares are therefore only interested in earning a return for that company' s systematic
risk. We will now look at systematic risk in more detail.
2.3
Systematic risk
There are good reasons why we are left with a considerable degree of systematic risk.
Sources of systematic risk
Business or trade cycle
There is an underlying cycle of business activity which will tend to affect all businesses at
the same time. Different business sectors may be hit earlier or later in the business cycle
and so sector diversification is important Diversification overseas will also help as not all
economies move in the same cycle. Even with overseas diversification there Is a
considerable degree of systematic risk because the whole international economy is highly
interdependent today.
Interest rates
Interest rates are a second economic influence that affects all businesses. They will affect
different businesses to different degrees depending on their level of borrowing, creating
specific risk. International business will be affected in different ways as interest rates can
vary considerably from country to country due to currency uncertainties and the state of the
local economy.
Inflation
Closely linked to interest rates is the rate of inflation. Inflation can affect companies in
different ways but generally, rising inflation will depress profits short-term. However, in the
long run price rises restore margins and profits have kept pace with inflation. No company
can expect to escape the impact of inflation so it is a systematic risk.
Tax
Tax, especially changes in tax, can have an impact on price levels and affect all companies.
CBl- 17: WACC
Page 17
This only applies to taxes that have an impact on all companies. Some taxes, eg a sales tax on
beer, will affect only those companies selling beer.
Currency
Currency movements will affect all companies trading in the affected countries to different
degrees.
Political events
International crises, wars, embargoes can all affect the global economy in a way that
everyone is affected.
Physical events
One may speculate that natural events or man made events could cause major
unpredictable systematic effects. The tsunami in the Indian Ocean in 2004 had a major
impact on some countries' economies. Climate change could have major economic impacts
resulting either from the environment or from transition effects In the economy.
This list is not exhaustive, but it does show that there are strong grounds for saying that
there will be risk in equity prices that is systematic and not specific to individual
companies.
Beta as a measure of systematic risk
We have said that shareholders only require a return for taking on systematic risk, because they
will diversify away the specific risk.
We have also said that all companies are exposed to systematic risk because they are all exposed
to the market. However, some companies are more exposed to the market than others and
therefore are exposed to a greater proportion of the systematic risk in the market.
We can compare individual stocks with the overall market by assessing the beta ( p) of the
stock.
Beta can be regarded as a measure of the systematic risk associated with a particular stock.
For company i:
P;=';f
m
where:
•
~ is the variance of the market index
•
u;m the covariance between the individual stock's return and that of the market.
An alternative expression for beta Is:
CT·
P; =p;m-'
Um
CBl-17: WACC
Page 18
where:
•
P;m is the correlation coefficient between the individual company's stock return and that
of the market
•
a; and am are the standard deviations of the company's stock return and the market
index respectively.
A value of beta in excess of 1 indicates a stock that has, historically, amplified the return of
the whole market (positive or negative).
A beta close to zero would indicate a stock that provided a more stable return than the
market as a whole.
A negative beta would signify a stock whose performance was counter cyclical, offsetting
the overall market experience.
If a stock has a beta of 2 in CAPM terminology, then:
•
for every 1% return achieved by the market above the risk-free rate of return, the stock
would be expected to achieve 2% more return
•
for every 1% return achieved by the market below the risk-free rate of return, the stock
would be expected to achieve 2% less return.
This stock is twice as volatile as the market as a whole.
Implications for the cost of equity
If the stockmarket prices risk efficiently, then a stock that has a higher standard deviation of
return (riskier) should be priced to offer a correspondingly higher return. For each 1% extra
return achieved by the market above the risk-free rate, the stock would be expected to return /3;
times that extra return.
Remember that the :
cost of equity in the market= risk-free return + equity risk premium
We can estimate the cost of equity for a particular company as being:
where:
•
r, is the risk-free rate
•
rm - r, is the market risk premium.
So the cost of equity for company i is:
CBl-17: WACC
Page 19
Q The key result of the Capital Asset Pricing Model is that for a single stock:
-
Cost of equity for stock = Risk-free rate + Equity risk premium x Beta for stock
rm -r1 is known as the market risk premium or the equity risk premium.
Ifill
Question
If the risk-free rate of return is 3% and the equity risk premium is 5%, calculate the cost of equity
for:
(i)
Company A with a beta of 1.7
(ii)
Company B with a beta of 1
(iii)
Company C with a beta of 0.4.
Solution
(i)
rA =3%+1.7 x 5%=11.5%
(ii)
r8 =3%+1 x 5%=8%
(iii)
re =3%+0.4 x 5%=5%
CAPM states that an investor will require a higher return to invest in a more volatile and risky
stock ( /3 >1) compared to the diversified market portfolio.
iJ
Question
If the risk-free rate of return is 5%, the equity risk premium derived from the market is 7% and
Fryday pie, an ungeared company (which pays no tax), has a beta of 1.2, calculate:
(i)
the expected return from the market
(ii)
the expected return from shares in the company
(iii)
the cost of capital used by the management in evaluating projects.
Solution
(i)
Market return
= risk-free return+ equity risk premium
= 5%+ 7%= 12%
(ii)
Equity share return
= risk-free return+ beta x equity risk premium
= 5%+ 1.2 X 7% = 13.4%
Page 20
(iii)
CBl-17: WACC
Cost of capital should be 13.4% as above to meet investors' expectations.
This assumes that no tax is payable and that a project that yields a return of 13.4% would
offer the same return to equity shareholders.
Adjusting beta for gearing
The beta of a company's shares, and hence the cost of equity, is affected by the company's
existing gearing. If the gearing were to change, then the volatility of returns would change, and
hence the beta would change. In certain situations, we can calculate the effect of changing the
gearing on beta by using the following formula:
6·
-
Geared beta = ungeared beta x {1 + debt:equity ratio x (1 - tax rate)}
This involves a formula relating a 'geared' beta with an ungeared beta.
The derivation of this formula is not required.
This formula assumes that all debt issued by the company can be issued at the risk-free rate. This
is seldom the case. However, it gives an approximate result where this is not the case .
Further complications arise when we look further down the tax chain, because the formula
assumes that investors receiving their returns in the form of bond interest or equity dividends
apply the same criteria . Of course these two types of income stream are taxed differently in the
hands of investors, so investors apply different criteria and require different returns from each
type of asset.
The company's current value of beta incorporates the effect of its current level of gearing.
If the gearing changes, the new beta must be found in two stages:
•
find the ungeared beta first
•
then find the new beta for the new level of gearing.
ffiiJ Question
Suppose Led pie has debt:equity ratio of 2:3, a beta of 1.2 and is taxed at 30%.
(i)
Calculate the beta of the company's shares if the company repaid all its debt.
(ii)
Calculate the beta if the debt:equity ratio increased to 3:2.
Page 21
CBl-17 : WACC
Solution
(i)
Ungeared beta
Using the formula:
and substituting values:
1.2 = Pu x( 1+½(1 - 0.3))
= Pu x l.4667
⇒
Pu=o.s1s2
(ii)
Geared beta with new debt:equity ratio
Therefore the new geared beta is:
Pg =0.8182 x( 1+}(1-0.3))
= 0.8182 X 2.05
=1.6773
Measuring beta
Historical returns
If historical returns are available over a number of periods, we can define:
•
r; to be the actual measured returns for stock i
•
rm to be the market returns over the same periods
•
•
•
r; to be the average of the measured returns of stock i
rm to be the average of the measured returns of the market
a-m to be the estimated standard deviation of the market returns
•
a; ,m to be the estimated covariance between the returns of stock i and returns of the
market
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CBl-17: WACC
We can then find:
I,(rmj _;m)2
I,[(rij - r;) x (rmj-rm)]
a-2 =~1~·- - - - and O';,m = ~1~·- - - - - - m
n-1
A
And hence estimate P; =
n-1
O"•
~,;'
O"m
Regression
Alternatively we can estimate /3; by regressing the share's returns against returns on the market
index. The regression fits the best estimate of beta in the model: 'i =rt+ /3; (rm -rt).
Quick method
The beta measures the additional return achieved by a stock relative to the market above the riskfree return. However in practice, given the imprecise nature of such analyses, the risk-free return
on a short-term basis (daily or weekly) is set equal to zero. So if, over short time periods, the
stock is observed on average to change by 60% of the market's change, it is said to have a beta of
0.6.
However, note that estimates of a company's beta, derived from regressing the company's
stock price performance on that of the market, will vary with the period over which the
estimation Is made. Additionally, an Internal estimate for beta will typically span a wide
range of values, due to the high standard error associated with the regression.
Using an industry beta
One way of improving the estimate is to use an industry beta based on a group of similar
companies.
By 'similar' we mean more than that they are all engaged In similar activities, as the nature
of their activities will only affect the business risk of the company or industry.
Geographic areas of operation will be Important, but we also need to ensure that they face
similar financial risk - that Is, that they have similar capital structures. Crude values of beta
derived from historic observations will be influenced by financial leverage (or gearing), and
this needs to be allowed for In our calculations.
Different companies have different levels of gearing. Since gearing affects beta, in estimating its
own beta, a company will need to adjust the industry beta to allow for any difference in gearing
between itself and the industry as a whole.
Betas for different sectors are not necessarily stable over time . By the time the observation
period is over, the market, the economic environment and the particular companies being
observed have all changed, so the beta estimated using past data will not necessarily be a good
estimate of the current or future value of beta.
CBl-17: WACC
2.4
Page 23
Market derived real discount rate
An alternative (approximate) way to calculate the cost of equity is to look at the dividend
yield and add this to the forecast future real growth rate of dividends.
A holder of an equity share receives an income stream and a capital gain caused by growth in the
share price. So an investor who paid P for an equity share will receive an annualised return on
this investment
annual dividend income
expected share price growth per annum
p
p
=---------+----'---------'----C.----'----=d+g
where dis the dividend yield and g is the annual rate of growth in share price.
The price of a share will grow each year in line with the growth in the dividend payable. In other
words g will in fact be the annual rate of growth in dividends.
Thus the total expected return from investing in a share is the dividend yield plus the growth in
dividends.
Because this method involves an estimate of the future capital growth rate, it is difficult and
potentially subjective to carry out.
If the market as a whole is made up of many rational investors, then the overall expected return
from an equity share (d + g) will be equal to the overall required return by all the investors. This is
one of the basic functions of the market - to find the equilibrium price at which investors'
required returns are matched by their expected returns.
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Page 24
3
Cost of debt
The cost of equity is only one component of the WACC .
We now need to consider the cost of the debt capital used by the company.
3.1
Marginal or average cost?
In deciding the relevant cost one needs to assess whether it is the marginal cost or the
average cost that matters.
Marginal cost adds new complexity. If new debt is being raised to help finance a project
then It would be reasonable to use the marginal cost.
The marginal cost is the cost of raising further debt. The average cost is the cost of the existing
plus new debt.
3.2
Determinants of the cost of debt
The cost of debt wlll vary from company to company depending on Its credit worthiness,
often expressed as a credit rating. The cost of debt will be related to the credit rating. The
lower the credit rating the more the company will have to pay for debt.
Interest and asset cover
The debt carrier will look at the security provided and the key components of this will be the
cover provided in the form of net assets to amount at risk and profits before tax and interest
to debt interest.
The credit rating agencies will assess risk of default that will depend on the level of Interest
cover and the volatility of the profit stream.
An investor in debt securities (a ' debt carrier') will worry about the company' s ability to repay the
nominal amount of the loan at maturity or earlier in the event of a wind-up, and will worry about
the company's ability to pay the interest payments on the debt.
As a reminder, this risk can be measured by looking at:
total assets - current liabilities - intangible assets
Asset cover =- - - - - - - - - - - - - - - - - loan capital+ (all priorrankingloanstocks)
and
profit before interest and taxation
Interest c o v e r = - - - - - - - - - - - - - - - - - - - - interest payable on loan stock+ all prior ranking loan stocks
Gearing
The marginal cost of debt will increase as the level of debt is pushed up because of the
adverse effect on the company's credit rating.
CBl-17: WACC
Page 25
Beta
The beta can therefore have a direct effect on the credit rating since a high beta will Indicate
more volatile profits. The level of gearing itself will increase the beta. There comes a point
where taking on further debt Increases the average cost of capital because of these
secondary effects.
Tax
The cost of debt capital can usually be offset against profits and serves to reduce the
effective cost of debt.
When a company pays one pound of debt interest, its profits before tax are reduced by one
pound. If the profit before tax is reduced, then the tax is reduced by £1 x t where t is the
corporation tax rate. Paying debt interest reduces the amount the company has to pay to the
government and so the 'net cost of debt' is lower than the 'gross cost of debt' .
A new company may not yet be in the position of making profits and so is at a disadvantage.
In assessing the cost of debt it is necessary to make an assumption as to when profits will
arise. A reduced rate of tax deduction to reflect the deferment may be used.
Thus:
Net cost of debt= Cost of debt depending on rating of company x (1 - tax rate)
Uiil
Question
Fryday pie is ungeared, has a beta of 1.2 and pays corporation tax at 30%.
Calculate the beta of the company' s equity shares if Fryday issued debt equal to 50% of its market
capitalisation and used the cash raised to repay half of the existing equity shares.
Solution
The gearing ratio of debt:equity would become 1:1.
geared equity beta
= ungeared Beta x [1 + (debt:equity ratio) x ( 1 - t )]
=1.2 x [1+1 x 0.7]
= 2.04
lmJ Question
Calculate Fryday pie's new WACC in a taxed situation, assuming that the new debt:equity ratio is
1:1 and that the gross cost of debt is the risk-free rate of 5% pa.
CBl-17: WACC
Page 26
Solution
The new beta is 2.04.
The new cost of equity is therefore:
5% + 2.04 X 7% = 19.28%
The net cost of debt will be:
5% X (1-0.3) = 3.5%
Thus the new WACC will be:
1
1
-( 19.28%) +-(3.5%) = 11.39%
2
2
Page 27
CBl-17: WACC
4
Weighted average cost of capital
4.1
The calculation of WACC
The Weighted Average Cost of Capital (WACC) is calculated by looking at the mix of debt and
equity actually employed and so will result In a value below the cost of equity. The relevant
formula Is:
Weighted Average Cost of Capital
= cost of equity x equity capital + net cost of debt x debt capital
total capital
The cost of equity is the required return by shareholders when they invest in the equity shares.
That is
cost of equity= risk-free rate+ geared beta x equity risk premium
When using the formula above it is important to remember the effect of gearing on the riskiness
(and hence the required return) from an equity share, due to the extra volatility and default risk.
To find out the effect on the cost of equity of increased gearing, first find the effect on beta by the
following formula:
geared beta = ungeared beta x {1 + gearing x {1 - tax rate)}
and then find the effect on the cost of equity.
The net cost of debt is the gross expected return by bondholders that are currently holding the
bonds - ie the gross redemption yield on the bond - adjusted for the favourable treatment of
debt finance in the corporation tax system. That is:
net cost of debt= gross cost of debt x {1 - tax rate)
Remember that the gross cost of debt depends on the company's credit rating.
The weighting factors are the market values of the various components of capital.
The above formula can be used to estimate the WACC at different debt:equity ratios.
CBl-17: WACC
Page28
Ifill Question
Spire pie has a debt:equity ratio of 1: 1. The risk-free rate of return is 4% pa, the equity risk
premium derived from the market is 6% pa and the gross cost of debt is 4% pa. Its beta is 1.5 and
any profit is taxed at 30%.
(i)
Calculate Spire's weighted average cost of capital.
(ii)
Spire is concerned about its high debt:equity ratio. If Spire were to repay all debt,
calculate the required return on equity.
(iii)
Spire decides against repaying all debt but instead embarks on a rights issue in order to
reduce its debt:equity ratio from its current position of 1:1 to a new position of 1:3.
Calculate its weighted average cost of capital after the rights issue.
State any assumptions made.
Solution
(i)
Spire pie's weighted average cost of capital
Spire pie's cost of equity
= risk-free return+ beta x (equity risk premium)
= 4% + (1.5 X 6%) = 13%
Spire pie's net cost of debt
= gross cost of debt x (1- t)
= 4% X 0.7 = 2.8%
Thus Spire pie's WACC
(ii)
= (0.5 X 13%) + (0.5 X 2.8%) = 7.9%.
The required return to equity if Spire pie were to repay all debt
To find the new required return on equity when Spire repays all debt, we need to find the
ungeared beta.
We can use the following formula:
to find the ungeared beta as follows:
= Pu x l.7
⇒
Pu =o.88235
CBl-17: WACC
Page 29
So the new cost of equity would be:
4% + (0.88235 X 6%) = 9.29%
(iii)
The weighted average cost of capitalfollowing the rights issue
To find the new required return to equity, we need to find the new geared beta.
/Jg = /Ju x( 1+ ~ (1-t))
=0.88235( 1+}(1-0.3))
=1.08823
So the new cost of equity will be:
4% + (1.08823 X 6%) = 10.53%
Assuming the net cost of debt remains at 2.8%, then the new WACC can be found .
Spire pie's WACC = (0.75 x 10.53%) + (0.25 x 2.8%) = 8.6% .
4.2
Uses of WACC
WACC is a consideration in the determination of the capital structure of the company (the
financing decision) and in the capital project appraisal process (the investment decision) which
are considered in Part 6 of the course.
Page30
CBl-17: WACC
The chapter summary starts on the next page so that you can
keep all the chapter summaries together for revision purposes.
Page 31
CBl-17: WACC
Chapter 17 Summary
Cost of capital
The weighted average cost of capital (WACC) is found as follows.
cost of equity x equity capital + net cost of debt x debt capital
WACC - - - - - - - - - - - - - - - - - - - - - total capital
Modigliani and Miller
According to Modigliani and Miller's first irrelevance proposition, the market value of any
firm is independent of its capital structure.
According to their second irrelevance proposition, the expected rate of return on the
company's shares increases in proportion to the debt-equity ratio, expressed in market
values.
These propositions are only valid under certain assumptions, in particular in a world with no
taxes.
CAPM and cost of equity
The CAPM offers many useful results, which can be used to evaluate a company's WACC.
The beta of a company is a measure of the systematic risk in terms of its business activities
and financing activities. It reflects the volatility of the company's share price and how the
share price returns are correlated with the returns from a fully diversified portfolio (the
market).
u
U.·
~
O"m
P; =-1!!1. and P; =P;m - '
The expected return from a share is related to its volatility (and beta) by the following
formula:
cost of equity = risk-free rate + beta x equity risk premium
where the beta is appropriate for the equity shares, and allows for the company's level of
gearing.
As a company increases its gearing, the level of systematic risk to equity investors varies.
The effect can be measured by the following formula:
geared beta= ungeared beta x {l + debt:equity ratio x (l -tax rate)}
CAPM and cost of debt
The tax system rewards the issue of debt and therefore the net cost of debt to a company
will be (1- tax rate) x the gross cost of debt.
CBl-17: WACC
Page 32
Risk
The risks of investing in a company's shares (or a project) can be divided into two types:
1.
Specific risk, ie the risk that the return from one company's shares (or one project)
may differ from the overall expected return from a well-diversified portfolio
containing many such shares (or many projects)
2.
Systematic risk, ie the risk that cannot be eliminated via diversification.
Systematic risks often come from sources such as:
•
the business cycle (eg growth or recession)
•
interest rates
•
inflation
•
taxation changes
•
currency movements
•
political events
•
physical events.
CBl- 17: WACC
Page 33
" ~
Chapter 17 Practice Questions
17.1
A company's shares have a beta of 0.75. The risk-free rate is 3% and the market risk premium is
5%. The corporation tax rate is 30%. Calculate the required rate of return on the company's
shares to two decimal places.
Exam style
17.2
Exam style
Which of the following statements is true?
A
B
C
D
17.3
Exam style
Which of the following is most likely to be true?
A
B
C
D
17.4
Exam styte
A
C
D
Exam style
It can be described as a 'defensive' company.
Investors in the company should expect a higher return over the long term than investors
in companies with low betas.
It has more systematic risk than an average company in the market.
Its cost of capital will be higher than that for a company with a low beta.
Which of the following statements is true?
A
B
C
D
17.6
A company's cost of equity will be equal to its weighted average cost of capital.
A company's cost of equity will be greater than its weighted average cost of capital.
A company's cost of equity will be lower than its weighted average cost of capital.
A company's cost of equity will fluctuate around its weighted average cost of capital.
Which of the following is NOT true about a company with a high beta?
B
17.5
The expected return from a share with a beta of 1.5 is 1.5 times the expected return from
a diversified portfolio of shares.
Defensive shares are defined as those whose beta is negative.
The expected return from a share with a beta of 0.8 is lower than the expected return
from a diversified portfolio of shares.
A company with a beta of less than 1 should not invest in risky projects.
All equity shares would have the same level of systematic risk if all companies had the
same level of gearing.
Systematic risk can be eliminated by investing in a large diversified portfolio of assets.
If a company increases its level of gearing it will increase its level of specific risk.
Increasing a company's gearing can reduce its weighted average cost of capital in a taxed
environment.
Explain how beta can be used to determine the appropriate risk discount rate used to appraise a
project and the main practical difficulty in using beta in this way.
CBl-17: WACC
Page 34
17.7
Exam style
Consider both Statement 1 and Statement 2 and decide, for each statement, whether it is true or
false.
If, and only if, you consider both statements to be true, you must decide whether Statement 2 is a
valid explanation as to why Statement 1 is true .
Statement 2 (Reason)
Statement 1 (Assertion)
An appropriate discount rate to use
in assessing a project can be
determined using the project's
beta.
BECAUSE
A project will involve only
systematic risk not specific risk.
A
1 true, 2 true, 2 is a valid explanation to support 1
B
C
D
E
1 true, 2 true, 2 is NOT a valid explanation to support 1
1 true, 2 false
1 false, 2 true
1 false, 2 false
CBl-17: WACC
•
Chapter 17 Solutions
17.1
Required rate of return= risk-free return+ beta x risk premium= 3% + 0.75 x 5% = 6.75%
17.2
Answer= C
r--,
Page 35
Return from a share with a beta of 1.5 = risk-free return+ 1.5 x equity risk premium, not
1.5 x (risk-free return+ risk premium). So A is incorrect.
Defensive shares are those with low positive betas, not negative betas. So Bis incorrect.
If the beta is 0.8 the expected return on the share (risk-free return+ 0.8 x risk premium) is lower
than the expected return from a diversified portfolio of shares (risk-free return + risk premium).
C is correct.
A company with a low beta is perfectly free to invest in high risk projects if it chooses. So D is also
incorrect.
17.3
Answer= B
The cost of equity is generally higher than the cost of debt because shareholders take a bigger risk
than holders of company debt and therefore require a higher return.
The weighted average cost of capital is a weighted average of the cost of debt and the cost of
equity. Thus, assuming the company has some debt finance, the weighted average must be lower
than the cost of equity.
17.4
Answer= A
A company with a low positive beta is described as a defensive company.
17.5
Answer= D
Equity shares have various betas. The beta depends on the systematic risk of the underlying
business and the level of gearing. Thus, even if all companies had the same level of gearing, some
businesses would still have higher levels of systematic risk. So A is incorrect.
Systematic risk cannot be eliminated by investing in a large diversified portfolio of assets. It is
specific risk that can be diversified away. So B is incorrect.
A company increasing its level of gearing would increase its systematic, not specific risk. So C is
incorrect.
Increasing gearing can reduce the WACC due to the tax efficiency of debt. So D is correct.
CBl-17: WACC
Page36
17.6
Useo/beta
If we are able to estimate the beta of a particular capital project, then we can use it to estimate
the appropriate risk discount rate to be used in the appraisal of that project from the relationship
rp = 't + /Jp (rm - r1 ) where rp and rm are the expected returns on the project and the market
respectively and r is the risk-free rate of return.
1
rp, which represents the rate of return that the investor should require given the level of
systematic risk in the project, is then used as the risk discount rate.
The main practical difficulty is that we are unlikely to have an accurate estimate of the beta for
any capital project, particularly as there is unlikely to be any relevant past history upon which to
base it.
One way around this difficulty in practice might be to use an estimated beta for a similar project
that is already in existence. However, it may be difficult to determine exactly what constitutes a
'similar' project.
An alternative is to measure the beta of the shares of a quoted company that undertakes the type
of project that we are considering, and use this beta as a proxy for the beta of the project.
17.7
Answer= C
An appropriate discount rate to use in assessing a project can be determined using the project's
beta, which reflects the level of the project's systematic risk.
The reason given is false, projects are exposed to both specific and systematic risk. However,
specific risks will not be reflected in the discount rate as they are assumed to be diversifiable.
Specific risks will be allowed for elsewhere in the project appraisal process, eg by reflecting the
likelihood a cashflow will be received/ paid.
CBl-17: WACC
Page 37
End of Part 5
What next?
1.
Briefly review the key areas of Part 5 and/or re-read the summaries at the end of
Chapters 15 to 17.
2.
Ensure you have attempted some of the Practice Questions at the end of each chapter in
Part 5. If you don't have time to do them all, you could save the remainder for use as part
of your revision.
3.
Attempt Assignment XS.
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CBl-18: Capital structure and dividend policy
Page 1
Capital structure and
dividend policy
Syllabus objectives
2.4
Factors a company should consider when deciding on its capital structure and
dividend policy:
1.
Impact of a chosen capital structure on the market valuation of the
company.
(Covered in part in this chapter.)
2.
Impact of taxation on the capital structure chosen by a company.
3.
Principal factors a company should consider in setting dividend policy and
the impact on the market valuation.
4.
Alternative ways of distributing profits, such as buybacks.
Page2
0
CBl-18: Capital structure and dividend policy
Introduction
In this chapter, firstly we investigate the gearing decision, ie the ratio of debt to equity in the
company's capital structure, and look at the factors affecting the gearing decision in practice.
Then we investigate the dividend decision under the following headings:
•
the fundamentals of dividend policy
•
other methods of rewarding shareholders
•
the market and dividends.
The examination could test, for example, knowledge of the factors affecting the gearing and
dividend decisions; understanding of the implications of a particular gearing or dividend decision
on a company; and the ability to evaluate the appropriateness of the gearing and dividend
decisions of a particular company.
CBl-18: Capital structure and dividend policy
1
Capital structure
1.1
Components of capital structure
Page 3
The components of the capital of a limited company are equity capital, short- and mediumterm debt and long-term debt.
When we discuss a company's capital structure, we are mainly concerned with the debt-equity
decision that the company takes. The proportion of debt to equity is measured by the gearing
ratio.
1.2
The aims of the financial manager
The financial managers of a company seek to maximise the return to the owners of the
equity, within the parameters that they have set out.
These Involve:
•
the variability of anticipated returns (having regard to the nature of the business)
•
the owners' desire for Immediate profit rather than future high growth
•
the willingness (or otherwise) of the owners to put additional capital into the
business
•
their willingness to see a reduction In the proportion of the business which they own
•
the degree to which risk should be carried by the owners.
The management of a company can control the variability of the profits (and hence the
risk) of the company, eg by:
increasing or decreasing the gearing
negotiating clauses in the contracts with suppliers which remove certain risks
taking out insurance against certain risks and the use of export guarantees
other risk management measures including financial risk control and financial
hedging using derivatives.
!
I Question
t ~t ------------------------------Describe how each of the above management actions might affect the expected return to
shareholders.
Solution
Increasing gearing
This would be expected to increase the volatility of return. Be cau se of the beneficial effect of
de bt on the company' s tax charge it would also be expected to increase the return on equity.
Page4
CBl-18: Capital structure and dividend policy
Supplier contract negotiation
Transferring risks to suppliers would be expected to decrease the volatility of the return to
shareholders. One would expect there to be a cost involved, which might reduce the return to
shareholders.
Insurance
As above, this should reduce the risk and volatility of return experienced by shareholders, but
might reduce the absolute expected return to shareholders.
Risk management and financial risk control
If carried out at no cost this should have a beneficial effect on the volatility of profits without
reducing the expected return. However, many risk control measures will incur a cost for the
company and therefore reduce shareholder returns.
When a company wishes to raise further capital for expansion, the existing shareholders normally
have pre-emptive rights that give them the right to buy shares to maintain the proportion of the
company they own. (The concept of rights issues was introduced in an earlier chapter.)
These rights give existing shareholders the opportunity to maintain their proportional
shareholding in the company, and hence their voting rights and their degree of control over the
company. If they do not wish to contribute any additional finance, they have two options:
•
Shareholders can attempt to stop the issue through their existing control. This is hard to
do in medium to large companies because the shares are so diversely owned, and
organising any combined action is difficult.
•
Shareholders can accept a reduction of their holding by selling their nil-paid rights. This
means that other investors are able to buy shares, and the proportion of the company
held by the original shareholders reduces.
t ✓r
Question
Explain why regulations normally require that shareholders have pre-emptive rights.
Solution
Shareholders have few controls on the managers of their company. Even the ultimate sanction of
voting the current management team out of their positions requires shareholders to find another
management team that can step in.
If the management were also free to raise capital and give away rights to future profit streams
whenever and to whomsoever they choose, then the amount of control is further reduced.
If a company is successful, the shareholders will want to benefit from that success. Pre-emptive
rights give shareholders the right to maintain a proportional holding of a company in order to
benefit from the company's growth. They also maintain their share of the voting rights.
CBl-18 : Capital structure and dividend policy
lift
Pages
Question
Greedy AG is quoted on the US Stock Exchange. Following its announcement that it is to have a
further rights issue, an investor is no longer willing to commit fresh funds to the company.
Calculate what proportion of the company the investor will own and the value of that holding
(assuming no unexpected share price movements) if the investor does nothing at all during the
rights issue.
The details are as follows:
Stock price:
$3 per share
Rights details:
one-for-two at $2.50 per share
Current holding:
investor holds 1,000,000 shares representing 1% of the company.
Solution
Value of investor's holding before issue= 3x1m = $3 million
Expected price of shares after issue
= ($ 3 x 2l + ($ 2 ·5 x l) = $2.83 per share
2+1
Value of nil-paid rights
= $2.83 - $2.5 = $0.33
If the investor does nothing, the nil-paid rights will be sold and the investor will be given the sum
of 500,000 x $0.33 = $166,000 in cash .
The holding of shares will be worth $2,833,000 (ie $3,000,000 - $166,000 or $2.83 x 1,000,000).
The proportion of the company owned was 1%. As there are now three shares in issue for every
two that existed prior to the rights issue, the proportion of the company will fall to ½%.
1.3
Assets and their financing needs
Assets of a business can be divided Into:
•
non-current assets such as land, property, plant, equipment and 'intangibles'
•
current assets such as inventories, work-in-progress, debtor balances, cash (and
equivalents).
The following table gives types of non-current and current assets that may be found in the
accounts of a typical petrol station:
Current assets
Non-current assets
Cash
Cash register
Oil
Petrol pumps
Debtors
Land & buildings
Page6
CBl-18: Capital structure and dividend policy
Current assets less current llabllltles form the working capital of the business and a certain
level of liquidity will be needed for a business to survive.
Also, in cyclical businesses current assets (and current liabilities) will fluctuate with the
cycle In that Industry.
Therefore both non-current and current assets have to be financed on a long-term basis.
1.4
Changing the capital structure
The need for change
In most cases, the need for change in capital structure arises from the desire to expand the
business or start new or additional capital projects.
Another reason for changing capital structure is where the business finds itself with excess
cash that it cannot profitably use, and so it returns this to shareholders by way of a share
'buyback'.
Companies may also wish to deliberately pursue a particular level of gearing. A company might
raise debt finance to fund a share buyback operation in order to increase its gearing, or to
minimise the WACC.
We will assume, however, that a company is raising finance to fund expansion.
Retained earnings
Retained profits are the simplest and most accessible source of finance. This Is especially
so for smaller or newer companies which may Incur high costs when seeking outside
finance relative to the amount being raised. In addition, because of the lack of a track
record, smaller companies may suffer from the effects of information asymmetries (that is,
even a sound, well-managed firm, may find It difficult to communicate its soundness
effectively to potential providers of capital - especially in equity markets).
However, retention of profits may be limited by the following:
•
Shareholders may demand immediate release of profits as dividends.
•
There may not be sufficient accumulated funds to finance projects when required.
It is notable, however, that many relatively new companies pay small or zero dividends in
their early years.
Retained earnings tend to be 'slow and steady' in nature, accruing gradually over the years. The
opposite is often true of expansion projects and takeovers, which can be very ' lumpy' in nature.
It can also be the case that the profits of a growing company are accounting profits and do not
accrue in the form of cash . This can make it difficult to use such profits to finance projects.
f k Question
t /1
Explain why accounting profits for a financial year might not equate to the increase in the cash
balance.
CBl- 18: Capital structure and dividend policy
Page 7
Solution
Some of the most obvious areas where accounting profits and cashflows would differ would be:
•
Sales : when a company signs a deal with a customer and registers the trade, the sale will
be added to the accounting profit. However, until the customer pays cash, the sale does
not represent a cashflow.
•
Purchasing non-current assets: when a building is purchased it represents a large cash
outflow. However, this is not registered as a cost in the P&L. The cost is 'depreciated'
through the accounts over many years.
•
Debt: If a company raises cash by increasing its borrowings the profit is unaffected.
However such action would obviously bring in a lot of cash resources.
•
Trade payables: if a company buys raw materials, it registers the cost in the P&L. In most
cases the company will only pay for the goods later, which is when the cashflow occurs.
Equity finance
Due to the cost, delay and unpopularity of raising new equity finance (particularly for
comparatively small sums), other forms of finance are typically used - at least Initially.
Other forms of finance
Most businesses can choose alternatives such as borrowing, lease of assets, sale and
leaseback or the use of trade credit to finance turnover. (Sale and leaseback is where the
owner of an asset sells it to an institutional Investor who then leases It back to the original
owner. In this way the owner releases the capital tied up In the asset.)
The use of these alternative forms of finance Is constrained by:
•
the nature of the business and Its assets
•
the degree of gearing considered acceptable
•
the effects of taxation
and these are reflected in the credit-worthiness rating of the business.
However, these alternative financing solutions have their drawbacks. Leased assets may
become of lower value than expected before the expiry of the lease (due to innovation or a
change In business strategy). Sale and leaseback forgoes flexibility and the possible future
appreciation In the value of the property.
Borrowing to finance projects is, therefore, typically required.
1.5
t
Theoretical background to the gearing decision
~ Question
~
Explain what the theories of Modigliani and Miller say about the effect of capital structure on the
market value of a company and the WACC.
Pages
CBl-18: Capital structure and dividend policy
Solution
Market value
Modigliani and Miller argued that, under certain assumptions, the market value of a company is
independent of its capital structure.
Their view was that the market value of a company is determined primarily by its investment
decisions and not by its financing decisions. This proposition allows complete separation of
investment and financing decisions.
WACC
Modigliani and Miller argued that the WACC is constant as gearing increases.
Raising the proportion of debt (which is cheaper than equity) does not reduce a company's WACC
because in response to an increase in debt, the cost of equity increases by just enough to
compensate for the increased volatility in earnings and to keep the WACC constant.
If gearing were completely irrelevant as the MM theories suggest, we would see that gearing
ratios varied randomly between industries and between firms within industries. Yet we don't see
this. Companies in particular industries are often fairly highly geared while companies in other
industries are not.
This suggests that gearing is important and that companies adjust their gearing until it is
appropriate.
There is an optimal capital structure but there is no golden rule: the optimal capital structure
might be different for different industries and for different firms within an industry.
1.6
Factors affecting the gearing decision in practice
The nature of the business and its assets
Some businesses - for example, banks and property companies - will use a high proportion
of debt financing due to the nature of their assets (loans to customers, leased properties).
Others - for example mineral prospectors or IT developers - will have very limited tangible
assets and will need to rely on equity finance. Most businesses, however, lie between these
two extremes.
In the case of high-risk businesses or businesses with very little asset backing (like advertising
agencies), banks are often unwilling to accept the types of risk involved in the company. An IT
company may not be able to provide the long-term guarantees required by the bank to enable the
bank to provide the finance, at least on the terms the company is willing to pay.
Many companies have very little in the way of physical assets to pledge as collateral for the loan
(eg management consultants). Their assets tend to be in the form of human capital. In such cases
the terms of the loan may be prohibitively expensive for the company to bear.
CBl-18: Capital structure and dividend policy
Page 9
Financial risk
As a business expands Its gearing - the ratio of debt to equity - the costs of financial failure
rise. In the end, losses can wipe out not merely the assets financed by the loans, but also
those financed by the equity, at which point the business is bankrupt.
This must be balanced against the higher expected return for the shareholders.
Consi der the following two scenarios for a property company, Company X:
(figures in £ millions)
Scenario1
Scenario2
Property
4
7
Cash
1
1
Total
5
8
Share capital
2
2
Loan stock
3
6
5
8
Assets
Liabilities
Total
Scenario 1 shows a geared company that has raised £2 million from shareholders and a further £3
million in the form of debt. It has used these funds to buy assets worth £5 million.
Scenario 2 differs from Scenario 1 only in the amount that the company has borrowed in the form
of debt to buy property .
Under Scenario 1, it would require a £2 million (or 50%) devaluation of property to wipe out the
value of the investment of the equity investors. In other words, if the value of property fell by
50%, the property and cash assets that the company owns would be worth £3 million, which is
just sufficient to pay the bondholders.
In Scenario 2 only a 29% drop in the value of the property portfolio is needed to wipe out all of
the equity investors' value (ie 29% of £7m is £2m) .
The potential reward for investors is greater under Scenario 2 because equity shareholders gain
more for each percentage point that the property portfolio increases in value. They will also gain
from fact that the financing cost of debt will be lower than the return the company is generating
on its assets, so even if property prices do not rise, equity shareholders will get a higher return.
However most investors would require a greater prospective return from their investment to
warrant taking the increased risk of Scenario 2. As such, the price they would be willing to pay for
the equity may well need to be lower - ie the price of the equity could fall in the secondary
market.
The greater the debt, the less likely It Is that the available assets (possibly realised In
'distress' circumstances) will be able to pay off all the creditors In full.
In addition, the holders of the equity will become concerned that, should the business hit a
bad patch, the interest burden will leave nothing for them.
CBl-18: Capital structure and dividend policy
Page 10
The cost of debt and equity
Debt finance is cheaper than equity finance because debtholders bear a lower risk than
shareholders. Also interest on debt finance is tax deductible whereas dividend payments are not.
However, as gearing increases, the cost of both debt and equity increases as the risk increases to
both lenders and shareholders.
Lenders will wish to consider the burden of existing debt before providing further funds.
Credit rating agencies monitor the financial status of major companies (and others, on
request). The down-rating of a company can have a major impact on the cost of its existing
debt and its ability to borrow more.
Companies have rolling overdraft facilities and short-term finance agreements with banks that are
often specifically linked to the company' s published credit rating.
Thus, a down-rating can have an immediate effect on the cost of borrowing. More obviously,
when a company rolls over its medium and long-term loans, the interest rate it will need to pay to
attract investors will be directly affected by investors' perception of its long-term credit
worthiness. Many investors are happy to let the credit rating agencies do this work for them , and
accept their judgement.
Companies often refer to the risk caused by such a down-rating as 'reputation risk'.
Availability of finance
This is very much linked with the last point. The company may wish to raise a particular form of
finance but the providers of debt or equity might be unwilling to provide it (or only at very high
rates of return).
If a particular project is large in comparison to the business as a whole, the lender may not be
prepared to lend the amount of capital required, and may wish to add covenants to the loan
agreement restricting the amount of further debt the company can raise.
f _,f
Question
Explain why a bank might be unwilling to finance the whole of a project, despite the fact that it
considers the project to be profitable and secure.
Solution
A bank will control its credit exposure in a number of ways. It will consider:
•
the amount of each loan as a proportion of its own share capital
•
the amount of each loan as a proportion of the borrowing company's share capital
•
the total amount of all similar loans (ie in the same sector or industry) on the bank's
books as a proportion of both of the above.
CBl-18: Capital structure and dividend policy
Page 11
Control of the business
Shareholders may not wish to see their control in the business diluted by increases in equity. In
this case, they could either take up any rights issues offered, or, if they did not wish to or could
not afford to take up any new rights, they could try to persuade the company to raise the funds in
an alternative way.
Managerial incentives and hence agency costs might change with gearing. As debt increases,
management might be less willing to invest in risky projects. Agency costs, ie costs of monitoring
management, might rise steeply beyond a certain level of gearing.
The market view
The stock market will consider every aspect of a company in making the assessment of
worth that culminates in a share price. If the capital structure does not appear consistent
with the other features of that assessment, the price will change to take that into account.
For example:
A high-growth company that is highly geared
Consider a medium-sized company In an Industry with numerous growth opportunities that
Is already highly geared compared with its rivals. The value of shares may be diminished
by the market's expectations that the shareholders will be asked to put up more funds.
It is argued that high-growth companies need financial slack, ie a cushion of equity, enabling them
to raise more debt finance easily when investment opportunities present themselves. Highgrowth companies therefore tend to be lowly geared.
In a static or low-growth Industry the converse will apply since a highly geared company Is
making more efficient use of the shareholders' funds.
Taking our property company X on page 9, there are three possible outcomes following the
increase in borrowing as the company moves from Scenario 1 to Scenario 2. One of the following
may occur:
•
Adding further debt to the company's financial structure is likely to reduce the interest
cover of the debt. Investors could become worried that the company may soon be forced
to raise more equity finance, because it can no longer finance the interest burden of the
debt. An increase in the supply of equity would depress the value of the existing equity.
•
Equity shareholders may become worried about the prospective volatility of market prices
of property and its effect on the residual value of the company. Due to fears that the
chances of a 29% down-valuation in property prices (ie sufficient under Scenario 2 to
bankrupt the company) are quite high, the value of the equity might fall.
•
Provided the property market was predicted to be quite stable investors might be quite
glad of the additional gearing. The equity shareholders will receive better returns from a
slow and steady increase in property values under Scenario 2. The addition of debt will
also make the structure of the company more tax efficient and offer higher returns to
equity shareholders.
Therefore the equity shares may appreciate in value because the new structure is better
suited to the investors' desired risk profile.
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CBl-18: Capital structure and dividend policy
A cyclical industry
The most efficient company will have a high debt to equity ratio when activity is at its peak,
but will be structured so that this debt can be reduced greatly as the trough approaches.
In a downturn, activity will reduce and the company will need less capital. Profits and therefore
interest cover will fall, so it is desirable to reduce debt finance.
Here It Is the term structure of the loan capital that will Influence the valuation of the equity.
An industry facing decline
In an industry facing decline, the management will need to diversify or go out of business.
If the company diversifies, it will be capital-hungry and will also need to adapt its capital
structure to that of the industry to which it is seeking to move while reducing (by
liquidation, If necessary) exposure to the business In decline.
If closure of the company Is chosen, then the less debt In the capital structure the better.
Declining industries can potentially be used as 'cash cows' to finance the diversification into
newer areas, reducing the requirement to raise further capital elsewhere with no further
investment needed in the old industry.
'People' businesses
Consider 'people' businesses, where the skills and abilities of certain groups of staff and
management are In very short supply and are essential to the competitive success of the
business.
It may be necessary to reward some individuals by stock options or other similar schemes.
However, excessive use of such arrangements can have an adverse effect on the valuation
of the company's shares.
Share options can have a very dilutive effect on the company's earnings. The directors or
management of the company are given the right to buy shares in the company at prices which
might be well below the current market price - however the value of these options need not be
reflected in the company's balance sheet.
When these options are exercised, the money paid to the company per share can be quite low,
but a normal share is created. The company's earnings are therefore divided between an everincreasing number of shares, reducing the earni ngs per share growth.
Microsoft issues share options worth billions of dollars to staff, none of which show up on the
balance sheet. They are disclosed in the notes to the accounts for those that want to investigate.
± ~ Question
t /1
Explain why investors might be concerned about the market value of outstanding share options in
a company.
CBl-18: Capital structure and dividend policy
Page 13
Solution
The market value of the outstanding options will be approximately equal to:
(current market value of the shares given away)
- (the amount the directors will have to pay in order to subscribe for those shares)
It can be seen that when the directors exercise their options, new shares will be created.
These new shares give the right to participate in the future profits of the company, and as such
have the same value as existing shares. However only the subscription amount will be received
by the company, which may be a lot less than the market value of those shares.
There will be 'dilution' to the extent that the amount received is less than the market value of the
shares issued.
Companies in high-growth but high-risk industries
In high-growth but high-risk Industries such as blo-technology or deep-sea oll exploration,
loan capital is unlikely to be available, but shareholders will need to be rewarded for the
risks they must bear In the absence of cashflow to fund dividends.
Conclusion
The more a company"s capital structure fits the market perception of the company"s
prospects, the higher the shares will be rated.
There are no simple rules of thumb - everything In the market's knowledge of the business
and its managers will contribute to the share price.
The managers will know more about the company than its shareholders, due to information
asymmetries. The market price of the shares will depend on the signals received by the
shareholders about the company from the managers.
This concern about the market reaction can affect management's decision making. An issue of
debt is often seen by the market as a sign of confidence on the part of management, whereas an
issue of equity is often thought to indicate that shares are overvalued. There may be a preferred
pecking order with companies choosing internal finance first, then debt, and finally equity.
Taxation
The main features of company taxation (as discussed in the chapter on taxation) imply that:
(i)
Interest payments are tax deductible.
The tax payable is consequently reduced .
(ii)
Capital allowances on new plant and equipment are deductible.
In other words companies can reduce their tax liability in respect of the capital allowances
on the plant and equipment they own.
Page 14
CBl -18: Capital st ructure and dividend policy
The amount and the structure of these allowances will influence a company' s desire to
invest in such equipment, which will influence their requirement for more finance.
(iii)
Lease of plant and equipment receives tax relief.
As above the amount of relief available will influence a company's financing decisions.
(Iv)
Property rental payments are tax deductible.
At a superficial level, it may seem that the cost of financing a business by debt capital is
diminished by the reduction in corporation tax, thus giving rise to a substantial tax
advantage to debt finance.
If a company borrows in the form of debt and buys assets that generate profits, the equity
shareholders will benefit from:
•
the fact that the payments of debt interest serve to reduce the tax liability
•
the fact that the assets themselves attract allowances which can reduce the tax liability.
If a company instead uses equity finance, then the first of these benefits does not occur. So, there
is a tax incentive for companies to prefer debt finance to equity finance, if everything else is
equal. However, not everything else is equal! Even when only considering tax, a company should
consider not only its own corporation tax, but also how the potential debt or equity investors will
be taxed. The investors' tax treatments will affect their willingness to provide different types of
finance and so the costs of the finance to the issuing company.
It should be borne In mind that the providers of debt capital may well have to pay tax on the
interest. Nevertheless, profits (the return on equity capital) are taxed more heavily than
interest (the return on debt capital) in most tax systems.
This partly arises because non-taxpayers cannot normally reclaim corporation tax paid by
the company itself on its profits. Those non-taxpayers may be people on low incomes,
pension funds (if they are tax exempt) or charities, or they may be shareholders who live in
countries with very low or zero taxes on Income from Investment.
Q As such, there Is a tax Incentive for companies to Increase gearing and take on more debt.
-
There are other situations where differing tax treatment might affect business behaviour
relating to, for example, decisions to lease rather than to own assets which might have
different tax implications.
CBl-18: Capital structure and dividend policy
1.7
Page 15
An illustration
We can demonstrate some of the above concepts using the statement of profit or loss of an
example company, WrongTurn Ltd. The company has investigated a potential project it would
like to undertake. It requires £5 million of additional capital.
Estimated statement of profit or loss for Wrong Turn Ltd for the year ended 31 December 20XX
(figures in£)
Operating profit
1,000,000
Interest payable on loan stock (£5 million @ 10%)
(500,000)
Profit before tax
500,000
Tax@30%
(150,000)
Profit after tax (Earnings)
350,000
Earnings per share
25p
The company made dividend payments of £196,000, ie 14p per share on 1.4 million shares, in
respect of the year ending 31 December 20XX.
Increase in retained earnings
154,000
If the shares currently stand in the market at a price of £2 per share and the dividend is the only
dividend paid during the year we can find:
..d d . Id dividend per share l%
d ,v, en y,e = - - - - - - - = o
share price
The return on equity capital for the shareholders (using market capitalisation as a proxy for share
capital and reserves) is
=
earnings attributable to equity shareholders
market value of equity shares
350,000
=- - - - - =12.5%
1,400,000x2
where the market value of equity shares = number of equity shares x share price
7% is the return in the form of immediate dividend yield and the remainder {of the 12.5%) is in
the form of dividend growth through retained earnings.
The company estimates that the project will give a return of 12% before taxes on the capital
raised - ie on £5 million of capital invested, it would yield £600,000 per year. However, this could
be as low as a 2% return {£100,000) or as high as a 22% return {£1,100,000).
Page 16
CBl-18: Capi tal structure and dividend policy
Scenario1
WrongTurn could raise the capital through an additional tranche of the loan stock @10%.
Assuming additional income of £600,000 the income account for the coming year might then be:
(figures in £)
Operating profit
1,600,000
Interest payable on loan stock (£10 million @ 10%)
(1,000,000)
Profit before tax
600,000
Tax@ 30%
(180,000)
Profit after tax (Earnings)
420,000
Earnings per share
30p
The company made dividend payments of £196,000, ie 14p per share on 1.4 million shares, in
respect of the year ending 31 December 20XX.
Increase in retained earnings
224,000
We assume that the company could issue more unsecured loan on the same terms as the existing
debt, ie at the Gross Redemption Yield (GRY) of 10% pa . In the real world a further issue would
doubtless reduce the credit worthiness of the loan and lead to an increase in the GRY of the entire
issue, including the new tranche.
This analysis also assumes the equity share price does not move in response to the expansion.
iJ
Question
Repeat the calculations for the situation where the additional operating profit from the new
project is £100,000 (ie 2%) and £1,100,000 (ie 22%).
CBl- 18: Capital structure and dividend policy
Page 17
Solution
2% return
22% return
1,100,000
2,100,000
(1,000,000)
(1,000,000)
Profit before tax
100,000
1,100,000
Tax@30%
(30,000)
(330,000)
Profit after tax (Earnings)
70,000
770,000
Sp
SSp
(126,000)
574,000
Operating profit
Interest payable on loan stock (£10 million@ 10%)
Earnings per share
lncrease/(decrease) in retained earnings
,r--------------------------
f I Question
+
If WrongTurn Ltd were to follow this route (Scenario 1), explain the possible effect on investors'
attitudes towards the shares, and explain what might happen to the share price in each case .
Solution
Possible outcomes include:
•
The business was already quite highly geared before the additional borrowing. With the
additional gearing in the form of the new debt, shareholders may become concerned
about whether there is sufficient interest cover.
There is a risk that interest rates will have increased when the company has to repay and
refinance the loan.
In order to carry that risk, investors may require a higher prospective return - ie the share
price may fall.
•
The further gearing reduces the chances of the equity holders receiving anything in event
of wind up, given the bondholders would be repaid first.
Given that this is a large project relative to the company as a whole, the chances of failure
must be uppermost in investors' minds. If they are concerned about the reduced asset
cover, the share price may fall.
•
Investors may be happy to have the additional gearing.
It gives them a higher prospective return immediately (the project adds value) and gives
them increased exposure to any upside risks for the company, so the share price may rise.
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CBl-18: Capital structure and dividend policy
Scenario2
Alternatively WrongTurn could raise the finance through an issue of equity. Assuming they were
sold at the current price of £2 per share (though it would be more usual to issue new shares at a
price below the current market price), £5 million would require the issue of an additional 2.5
million shares.
Operating profit
1,600,000
Interest payable on loan stock (£5 million@ 10%)
(500,000)
Profit before tax
1,100,000
Tax@30%
(330,000)
Profit after tax (Earnings)
770,000
Earnings per share
19.74p
The company made dividend payments of £546,000, ie 14p per share on 3.9 m illion shares, in
respect of the year ending 31 December 20XX.
Increase in retained earnings
224,000
Again this analysis assumes that the share price does not move in response to the expansion.
Comparing Scenario 2 with Scenario 1, we can see that WrongTurn has paid £150, 000 more in tax
on its profits, simply because of the way in which it has chosen to finance the expansion.
---------------------------------f , tI -Question
!
Repeat these calculations for Scenario 2 for the situation where the additional operating profit
from the new project is £100,000 and £1,100,000. Compare the answers with those obtained in
the previous calculation.
Solution
2% return
22% return
Operating profit
1,100,000
2,100,000
Interest payable on loan stock (£5 million@ 10%)
(500,000)
(500,000)
Profit before tax
600,000
1,600,000
Tax@30%
(180,000)
(480,000)
Profit after tax (Earnings)
420,000
1,120,000
10.Bp
28.lp
Earnings per share
The company made dividend payments of £546,000, ie 14p per share on 3.9 million shares, in
respect of the year ending 31 December 20XX.
lncrease/(decrease) in retained earnings
(126,000)
The volatility of returns is far greater in the more highly geared situation (Scenario 1).
574,000
CBl-18: Capital structure and dividend policy
f ;f
Page 19
Question
Describe the possible impact on the share price for WrongTurn Ltd under Scenario 2.
Solution
Possible outcomes are:
•
The gearing of the company is reduced under this scenario, so the investors may feel this
is not the best use of capital. Their prospective return has been reduced, causing the
share price to fall.
•
The gearing of the company could have been considered too high in the first place. The
extra share capital reduces the risk of the company not being able to finance its interest
payments. This could be perceived as positive and the share price would rise.
•
The increased marketability of the shares may be welcomed and the share price may rise.
•
The additional supply of equity could have a short-term effect on the value of the shares,
and drive the price down. This would only be a short-term effect, and has little to do with
the fundamental value of the shares themselves.
There is therefore a powerful tax incentive for a company to borrow (or finance assets through a
lease, etc) when it needs capital for expansion. However, the costs of some partial failure of the
business can exceed the tax benefit that has been obtained in respect of the project and its
financing.
In the case of WrongTurn above, an estimate might be made of the effect on the share price
under both the scenarios. Whichever is most likely to lead to a higher share price, is by definition
the option which shareholders feel happiest with.
Shareholders may prefer an issue of debt (Scenario 1} because of the utilisation of the tax benefit
and the higher prospective return to shareholders of the geared strategy.
Alternatively, shareholders might prefer the issue of shares (Scenario 2) despite the lower
prospective return and tax disadvantages, due to the lower gearing and the reduced volatility of
earnings.
CBl- 18: Capital structure and dividend policy
Page 20
2
Dividend - the shareholders' reward
2.1
Fundamentals of dividend policy
Dividends can be seen as a financing decision - money paid out by way of dividend is no
longer avallable for Investment In the business. This Is particularly true of unlisted
companies since:
•
the company does not have the option of raising further funds in the stock market
•
the borrowing powers of unlisted companies tend to be more restricted.
On the other hand, shareholders in such companies have the opposite problem - they
cannot sell some shares In the market to replace dividend Income.
In general, the choice for a company's board (and Its shareholders) is between immediate
income and the prospect of higher income at some future date. The latter will, in a listed
company, be reflected in capital appreciation as the market takes that prospect into
account.
Factors influencing the decision on dividend policy include:
The main factors influencing the dividend decision include:
•
opportunity cost
•
stock markets
•
•
cash reserves
tax
•
growth opportunities
•
stability and consistency.
Opportunity cost
Companies should not retain profits If the rate of return they can achieve on re-Investment
is less than their investors' required rate of return which will be determined in large part by
the returns and risks relating to alternative investment opportunities.
An alternative opportunity would be preferred if it offered a higher expected rate of return for
the same level of risk or the same expected rate of return for a lower level of risk.
Stock markets
Stock markets display significant adverse reactions to announcements of dividend cuts.
Managers therefore tend to conservatism in good years, particularly in cyclical industries
and for smaller companies (especially those that are new to the market).
1
±~
Question
,I --------------------------The stock market is often accused of being too focused on the short term . Explain how this could
have a negative effect on a company's long-term growth prospects.
CBl-18: Capital structure and dividend policy
Page 21
Solution
If the stock market is focused on the short term, it is possible that investors will reward
companies that pay high dividends with a high share price.
Companies may then return too much to shareholders, rather than focusing on the payout ratio
that best suits their business, which may be bad for the company' s long-term prospects.
A change of dividend policy can have significant repercussions for a company's market
rating and its capacity to raise finance.
Cash reserves
Companies with large cash reserves that fear a takeover bid may well distribute generously
to both encourage shareholder loyalty and limit the size of the 'cash pile'.
A cash pile is seen by investors as a sign of weakness.
Some companies try to label it as a ' war chest' - cash held in anticipation of a large aggressive
takeover bid - in the hope that the market will continue to believe that some big value-adding
manoeuvre is imminent.
Shareholders invest in companies to get exposure to a certain type of risk. If they wished to
invest it in cash or other investments, they would choose to do it themselves through direct
investment, rather than let the company do it for them.
So the belief is that if the company can't use the money they should give it back to shareholders.
Shareholders can then find another company that has some ideas and that can use the cash!
Tax
Companies with a large proportion of non-taxpaying shareholders may feel It appropriate to
distribute a large proportion of earnings.
In general, non-taxpaying shareholders (and those who receive dividend income tax-free,
eg because the income is below the tax-free dividend limit) will wish to receive much of their
return in the form of income, rather than reinvesting the profits in the company to give a capital
gain. This will lead to a bias towards higher payouts from companies whose shareholder base
contains a higher proportion of non-taxpaying shareholders or smaller investors.
Growth opportunities
Companies in high-growth industries may find that the demands for capital investment to
maintain competitive advantage exceed their capacity to borrow on satisfactory terms and
may prefer to pay low dividends rather than making frequent rights issues.
Many internet companies pay no dividend at all, and often have negative net cashflow. It is the
promise of superior growth in the future that makes these companies attractive, not a high
dividend yield. So paying a dividend to the sort of investor who invests in such companies makes
little sense.
CBl-18: Capital structure and dividend policy
Page 22
Stability and consistency
Since companies with high dividend policies tend to attract investors who seek high
payouts {and similarly for low dividend policies and preferences) any move from one
category to the other will cause adverse market reaction as investors readjust their
portfolios.
t~
Question
State the types of investors that might have a preference for low payout policies_
Solution
Investors who may have a preference for companies with low payout ratios are investors who:
•
prefer capital gains to income from a tax point of view
•
have no current need for cash
•
believe the company can reinvest the cash better than they can
•
are also managers of the company, and want resources now.
f /~
Question
State any legal constraints on the amount of dividend that can be distributed.
Solution
Companies are not allowed to pay out in dividends more than they have in their retained earnings
from the current and previous years. This is to protect creditors in the event of the company
being wound up.
2.2
Other methods of reward
Introduction
In addition to regular dividends, usually paid quarterly or half-yearly, one-off extra or special
dividends may be paid occasionally.
Alternatives to cash dividends Include:
•
scrip, stock or share dividends
•
share buybacks.
Occasionally, companies may offer non-cash dividends in the form of product samples or
discounts on services.
Often companies will offer an automatic dividend reinvestment plan. This may include the
issue of new shares at a discount to market price {partly to reflect the saving in
underwriting costs).
CBl-18: Capital structure and dividend policy
Page 23
Shareholders are offered the opportunity to reinvest their dividends in the company's shares,
which are offered at a discount.
Scrip, stock or share dividends
Stock or share dividends are paid in the form of extra shares, rather than cash.
Such a dividend will be shown in the company accounts as a transfer from retained
earnings to equity capital.
Scrip dividends are similar, but the shareholder may have the option to choose the form of
dividend payment they prefer, cash or extra shares.
Scrip dividends are defined as either 'pure', where the shareholder has no option to take
cash, or as a scrip alternative to a cash dividend.
For example, a scrip, stock or share dividend might involve a shareholder receiving a new share
for every 20 shares they hold. This is equivalent to a 5% dividend yield. Tax issues rise, since the
authorities require that the value of the new shares allocated are treated as taxable income.
Effect on the company
These methods of distribution are of benefit to companies that either:
•
have no cash with which to pay a dividend because of long-term expansion
•
usually paid a dividend, but are unable to pay one at present.
If they expect to resume paying dividends in the future, and wish the dividend yield to be
continuous through these hard times, they may pay a scrip dividend.
From the company's point of view, the scrip dividend retains funds to be used for
Investment or to reduce borrowings and, therefore, to Improve earnings. The capital base
will Increase and this will improve the company's financial capacity. The shareholder base
may be Increased by attracting Investors who prefer scrip dividends.
f I Question
t ~r - - - - - - - - - - - - - - - - - - - - - - - - - - - - - A company is debating whether to pay no dividend or to pay a scrip dividend.
Explain which option is expected to lead to a faster appreciation of the share price over time.
Solution
The 'no dividend' option allows the company to retain all of its earnings, and involves no dilution
of earnings (reduction of earning per share) through the issue of new shares. It would therefore
lead to the fastest capital appreciation. Scrip dividends reduce the share price slightly because of
the resultant dilution of earnings.
Effect on the shareholder
From the shareholder's point of view, there are fewer benefits.
Page 24
CBl -18: Capital structure and dividend policy
Tax will normally be payable as If cash had been taken but, as no cash Is received by the
shareholder, this must be funded out of other resources.
The scrip issue only benefits those shareholders who wish to increase their holdings, as
they will avoid brokerage and other acquisition costs and may also benefit from a slightly
better price. On the other hand, the practice complicates the computation and recording of
capital gains.
Share buybacks
If a company has accumulated large amounts of cash which It does not need In running the
business, or if it wishes to change its capital structure by replacing equity with debt, it will
generally undertake a share repurchase or buyback exercise.
The procedure
The company announces that it intends to buy back a certain number of its own shares.
This may be Implemented by:
•
purchase of shares in the open market, often by a gradual programme over a period
of time
•
a fixed price offer
•
a tender offer (either a Dutch or uniform price auction)
•
repurchase by direct negotiation with a major shareholder.
The most common method is for the company to announce its intention of buying its shares in
the open market.
If the company repurchases a stated number of shares at a fixed price (typically at a significantly
higher price than the current market value), the shareholders are informed of the company's
intention and are free to accept the offer or not.
If a uniform price auction is used, the company asks shareholders how many shares they are
prepared to sell and at what price.
Suppose:
•
shareholder A is willing to sell 10,000 shares at £2
•
shareholder Bis willing to sell 15,000 at £3
•
shareholder C is willing to sell 20,000 shares at £4.
The company will then calculate a price at which it can buy the number of shares it wishes to buy.
If it wishes to buy 25,000 shares, it w ill pay £3 per share to shareholders A and B.
If a Dutch auction is used, the company states a series of prices at which it is prepared to
repurchase shares. Shareholders reply to this offer, informing the company of how many shares
they are willing to sell at each price.
The company then calculates the lowest price at which it can buy the required number of shares.
CBl-18: Capital structure and dividend policy
Page 25
Effects on the shareholders
Often, for simple supply/demand reasons the share price rises on such an announcement.
However, this is not always the case.
Investors invest in a company with the intention of being exposed to a certain type of risk (and
hopefully a certain return). The company is essentially forcing some investors to sell their shares
and invest elsewhere.
Such an announcement can also be seen as a sign of weakness by investors, who may think that
the company has no ideas or innovative projects to generate returns. On the other hand, some
might argue that it is good to reduce the stockpile of cash, since it will not have been earning a
great rate of return.
There are also tax issues to consi der.
•
Some investors might be happy to realise a capital gain if they have not used their capital
gains allowance because they will pay no tax on the capital gain.
•
However othe r investors may be forced into realising capital gains at times when they
would rather not, eg if their year's allowance is already used up.
Share buybacks have been a common way of rewarding shareholders in the United States
because, until recently, shareholders had to pay income tax on dividend income on top of the
corporation tax paid by the company on its profits.
Share buybacks can benefit private shareholders to the extent that the tax treatment of
capital gains is better than that of dividends.
The effect on the company's earnings per share should be beneficial, since the cash held is
probably only earning a deposit rate of interest - much less than its industrial assets. The
value of the remaining shares should, therefore, Improve.
However, investing institutions prefer to make their own buy/sell decisions and receive no
tax benefit from a share buyback, so this alternative is more frequently carried out by
companies with a high proportion of individual shareholders.
2.3
The market and dividends
The market value of a company is the market's valuation of future dividends (unless there
are expectations of takeover or winding up and the distribution of residual assets).
In many cases, such as internet based companies and high-tech stocks, the first prospect of a
dividend payment can be many years in the future. Under these circumstances it becomes very
hard to value companies by this method.
If no outside loan capital is available and the company has better investment opportunities
than its shareholders, then the payment of dividends will reduce the business' ability to take
advantage of these situations and will be damaging to the market value of the company.
However, provided loan capital is available to the company on tolerable terms, this
restriction does not apply (and even after this Is exhausted there is always the possibility of
a rights issue).
CBl -18: Capital structure and dividend policy
Page 26
Looking at the dividend question from the point of view of the shareholder, it is a
reasonable assumption that the purchaser of shares has some expectation of a dividend
policy. If this expectation is not fulfilled, it will change the investor's relative valuation of
the share.
A consistent dividend policy is, therefore, important in building a clientele of investors, and
an unexpected change can have a negative effect on perceptions of the company's worth. It
follows that Investors will move to shares where dividend pollcy Is compatible with (or
acceptable in) their tax position.
1
1 Question
t / f --------------------------------A large well-established company GHJ has run upon hard times. Having had robust and increasing
profits for the last ten years, half of which it has paid in the form of dividends, it has been hit by
recession in three of the four industrial areas in which it operates. The directors are keen to
maintain investor loyalty, and are afraid of a takeover by another company. However they accept
that the profits in the current financial year will be zero.
State what further information would be required in order to set the dividend policy for the
coming year.
Solution
Addition information required includes:
•
whether the company can afford to pay a dividend
•
when the profits are going to recover to their former level
•
whether the company can pay scrip dividends in order to preserve cash
•
whether other companies in the sector are struggling and the dividends they are paying.
The financial management of a company must, therefore, consider carefully the llkely effect
on investor perception of any dividend announcement - particularly if it can be construed
as a change in dividend policy.
If a change should be necessary, It Is necessary to explain the reasons quickly and clearly shareholders will generally accept decisions made for the long-term benefit of the
shareholders. Any efficient market will take Its cue from the statements and actions that
enter the publlc domain, not from what a company's managers wish or think.
t .-,f
Question
Set out possible courses of action for the management of company GHJ.
CBl- 18: Capital structure and dividend policy
Page 27
Solution
•
Maintain the dividend despite the fall in profits.
•
Declare a scrip dividend equal in size to the previous actual dividend.
•
Declare a postponement of dividend payments until the company is profitable again.
•
Estimate the sustainable profitability of the company over the next few years and scale
the previous dividend down to reflect this lower expectation in the future .
Page28
CBl-18: Capital structure and dividend policy
The chapter summary starts on the next page so that you can
keep all the chapter summaries together for revision purposes.
CBl-18: Capital structure and dividend policy
Page 29
Chapter 18 Summary
Capital structure
The management has a great deal of flexibility as to how a company's capital should be
structured. It is important that they manage the capital structure in a suitable manner.
Factors influencing the gearing decision are:
•
business risk
If the business is in a volatile industry, it may better to avoid too much debt, as it
would increase the risk of wind up.
•
financial risk
Also, as the level of gearing rises, the service cost of the debt will rise due to the
added risk of default. The return on equity will no longer benefit from further
gearing.
•
cost of raising and servicing the capital
Depending on the capital structure, issuing more debt finance may reduce the
WACC.
•
availability of debt and equity finance
Additional debt finance may not be available if the company is already highly geared
or has few tangible assets.
•
effect on control of the company
Raising funds through the issue of equity causes a reduction of the existing
shareholders' proportional holding in the company if shareholders are not able or
willing to buy the new shares.
•
market view
Ultimately, the market will reflect its view on the capital structure through the
company's share price.
•
taxation
Debt finance is generally advantageous in a world with tax. Debt finance costs are
deducted from pre-tax profits, thereby reducing the amount of tax payable.
Page30
CBl-18: Capital structure and dividend policy
Dividend policy
Key factors in the dividend decision are:
•
opportunity cost- companies should not retain profits if investors would prefer to
invest dividends in alternative investment opportunities
•
stock market reaction eg adverse reaction to dividend cuts, competitors' policies
•
cash reserves - cash -rich companies might give a generous dividend or might buy
back shares; cash-poor companies might give no dividend or perhaps a scrip dividend
•
tax - investors prefer dividends if they are taxed at a higher rate on capital gains
•
growth opportunities - if these exist it may be better to retain profits
•
stability and consistency with previous dividend policy
•
investor preferences eg need for cash, better opportunities to invest elsewhere.
Other ways of rewarding shareholders include scrip dividends and share buybacks.
CBl-18: Capital structure and dividend policy
Page 31
" ~
Chapter 18 Practice Questions
18.1
Which of the following types of company is most likely to employ a high proportion of equity
Exam style
financing?
A
B
supermarket
property company
C
D
IT company
bank
18.2
A company owns and occupies a large office in a prime location. In order to reduce the level of
Exam style
company debt, one of the directors has suggested that the company should approach a bank to
arrange a sale and leaseback on the property, whereby the company will sell the property to the
bank for a sub-market price and enter into a long-term lease on the office at a sub-market rent
level. Which of the following is NOT a disadvantage of the director's proposal?
A
B
C
The company would lose out on any future growth in the value of the office.
The company will face the cost and obligations of maintaining the building.
The company may be restricted in what it can do with the property in future, eg subletting surplus space if the company's business declined.
D
18.3
Exam style
If the bank fails to keep its side of the agreement, the company will have let the property
go below market value without any benefit.
Company XYZ is seeking finance for expansion. The Chief Executive states that there should be
sufficient funds raised internally through retained earnings to fund business growth over the
medium and long term and that other methods of raising finance are too expensive so should be
avoided.
Retained earnings are a good way of funding growth by acquisition in particular.
II
Growth strategies should not be restricted to the amount of the retained earnings.
Ill
Use of other methods of raising finance may increase the company's WACC and so using
them to finance expansion projects would go against the maximisation of shareholder
value.
Which of the statements is/are true?
A
I only
B
C
II only
I and II only
D
I and Ill only
CBl-18: Capital structure and dividend policy
Page 32
18.4
Exam style
A bank's board is considering the level of dividend the bank should pay in a particular year.
Decide whether each of the factors below is likely to increase or decrease the dividend amount.
Consider each factor in isolation.
The bank makes stable profits.
[INCREASE / DECREASE]
The level of competition between banks is increasing.
[INCREASE / DECREASE]
Other banks are cutting dividends.
[INCREASE / DECREASE]
The bank's growth plans include investment in improving its digital capabilities for both staff and
customers.
18.5
[INCREASE/ DECREASE]
A company proudly announces that its free cash reserves have reached record levels, making it
the financially strongest company in its sector.
18.6
Exam style
(i)
Describe the possible shareholder reactions to the statement.
(ii)
Outline how the company could reduce the cash pile.
A company is considering some of the ways in which it might carry out a share buyback
programme. Select the correct option in each case in the following descriptions of three of the
ways it is considering.
On the open market. The company could instruct its stockbroker to purchase its own shares on
the stockmarket. The company runs the risk of driving its own share price [DOWN/ UP] .
Through an offer to shareholders at a fixed price: The company could write to shareholders
offering to buy shares at a fixed price, usually slightly [BELOW/ ABOVE] the current market price.
Through a [DUTCH/ UNIFORM] price auction whereby the company would ask each shareholder
how many shares they would be willing to sell and at what price.
18.7
Consider both Statement 1 and Statement 2 and decide, for each statement, whether it is true or
false.
Exam style
If, and only if, you consider both statements to be true, you must decide whether Statement 2 is a
valid explanation as to why Statement 1 is true.
Statement 1 (Assertion)
Share buybacks are always more
Statement 2 (Reason)
BECAUSE
Proceeds from a share buyback are
tax-efficient for investors than
treated as capital gains and special
special dividends.
dividends are treated as income for
tax purposes.
A
B
1 true, 2 true, 2 is a valid explanation to support 1
1 true, 2 true, 2 is NOT a valid explanation to support 1
C
1 true, 2 false
D
1 false, 2 true
E
1 false, 2 false
CBl-18: Capital structure and dividend policy
Page 33
~~ Chapter 18 Solutions
18.1
Answer= C
It is difficult to obtain debt finance without security in the form of tangible assets. Since an IT
company is unlikely to have many tangible assets, and in the early years be making no profits to
pay interest, the main form of finance available is likely to be equity finance.
18.2
Answer = B
Selling the office and entering into a lease would bring the advantage of releasing the company
from the costs and obligations of maintaining the office and all of the potential liabilities which go
along with owning a building.
18.3
Answer = B
I is false. Retained earnings tend to be slow and steady in nature. Growth, particularly growth by
acquisition, can be more 'lumpy'.
II is true . Growth strategies should not be restricted to the amount of the retained earnings.
Ill is false. Using other methods of raising finance may increase the company's WACC, but
provided the growth is expected to achieve a higher return than the WACC this still meets the aim
of maximising shareholder value.
18.4
The bank makes stable profits.
INCREASE
DECREASE
The level of competition between banks is increasing.
More competition between banks may squeeze the bank's future profits and so dividends.
Other banks are cutting dividends.
DECREASE
The bank's growth plans include investment in improving its digital capabilities for both staff and
customers.
18.S
(i)
DECREASE
Shareholder reaction
The announcement may be received positively if:
•
the shareholders feel comforted by the strong financial situation
•
the company's financial strength allows the company to do business in markets that it
could not otherwise.
The announcement may be received negatively if:
•
the reserves are invested in low-yielding financial assets, so the cash pile is not serving a
purpose and is an inefficient use of capital
•
it is taken as an indication that the company has no ideas with which to expand the
business.
CBl-18: Ca pital structure and dividend poli cy
Page 34
(ii)
Reducing the cash pile
The company could reduce the cash pile by:
•
paying higher dividends - this is likely to reduce the cash pile only slowly over time
•
paying a special dividend - this would have a larger short-term effect
•
a share buyback - this could be done either by buying the shares in the market, or by
making an open tender to all shareholders, or by direct negotiation with a number of
larger shareholders
•
18.6
a takeover of another company for cash .
On the open market. The company could instruct its stockbroker to purchase its own shares on
the stockmarket. The company runs the risk of driving its own share price UP.
The share price being driven up is a risk for the company as it would make the share buyback
programme more expensive.
Through an offer to shareholders at a fixed price: The company could write to shareholders
offering to buy shares at a fixed price, usually slightly ABOVE the current market price.
Through a UNIFORM price auction whereby the company would ask each shareholder how many
shares they would be willing to sell and at what price .
A Dutch auction would involve the company asking each shareholder how many shares they would
be willing to sell at a series of set prices. From this information, the company could calculate the
lowest pri ce at which it could buy the required number of shares.
18.7
Answer = D
It is true that any share buyback profits made by the investor when selling the shares back to the
company are treated as capital gains whereas special dividends are income.
As a result, a share buyback will be more tax-efficient than a special dividend for investors who
have unused capital gains allowances but are taxed on their income, eg some individual investors.
However, not every investor's tax position is the same and so buybacks are not always more taxefficient. In particular, share buybacks would not offer greater tax-efficiency for investors who
are exempt from tax or who are taxed in the same way on both income and gains, eg investing
companies where both income and gains form part of taxable profit.
CBl-19: Capital project appraisal (1)
Page 1
Capital project appraisal (1)
Syllabus objectives
3.1
Interaction of the cost of capital of a company with the nature of the investment
projects it undertakes:
3.
Principal methods used to determine the viability of a capital project.
4.
Cashflow projections and the application of techniques to estimate
cashflows.
5.
Methods used to evaluate risky investments including simulation, scenario
planning and certainty equivalents.
(Covered in part in this chapter.)
10.
Techniques to ascertain the distribution of possible financial outcomes of a
capital project.
CBl-19: Capital project appraisal (1 )
Page2
0
Introduction
Companies use real assets to carry out projects in order to generate profits for their shareholders.
Before proceeding with a particular project it should be thoroughly appraised in order to
determine if it is likely to be profitable and hence worth undertaking. It is this appraisal of capital
projects that we discuss in this and the following chapter.
In order to acquire the assets to undertake projects the company must raise finance. So, the basic
requirement of a capital project is that the returns from the project should exceed the cost of the
capital employed to generate those returns. However, as the returns from projects are always
uncertain, so project appraisal can only ever indicate the likely profitability of a project and
cannot give definite answers.
The structure of this chapter is as follows:
•
Firstly, we define exactly what we mean by a capital project and then discuss how to carry
out an initial appraisal and discuss the scope of the project.
•
We then consider some of the main methods typically used to evaluate the likely
profitability of projects in practice. The most common methods are discounted cashflow
techniques, such as net present value (NPV) and the internal rate of return (IRR).
•
Finally, we consider how to interpret the result of the numerical evaluation of the project
and how we can gain a fuller understanding of the viability of a project by the use of
simulation techniques.
This chapter is concerned mainly with the methods of investment appraisal. The next chapter will
consider in more detail how to :
1.
calculate the required rate of return for a project ie choose the discount rate to be used
2.
identify and mitigate a project' s risks.
To help see how the whole capital project appraisal process fits together, there is an overview
diagram on the next page.
CBl- 19: Capital project appraisal (1)
Page3
Identify project
opportunity
Initial appraisal
No: abandon project
Yes
Scope
Techniques, eg NPV, IRR
Risk discount rate
Evaluate project
Simulation
Identify risks
Analyse risks
Methods
Mitigate risks
~ Assessment of mitigation methods
No: abandon project
Yes : start implementing the
project
CBl-19: Capital project appraisal (1)
Page 4
1
Introduction to capital project appraisal
1.1
Definition of a capital project
By a capital project we mean any project where there is initial expenditure and then, once
the project comes into operation, a stream of revenues less running costs.
A capital project does not have to Involve the construction of a physical asset.
The key feature of a capital project is really that it involves the creation of a new asset or the
transformation of an existing asset into a different asset.
In this context, asset refers to anything that will generate future positive cashflows for its owner.
Capital projects therefore exclude the transfer of ownership of an existing asset- eg the purchase
of an ordinary share in an existing company.
Examples of capital projects would include the:
•
construction of fixed capital assets, eg new factories or aeroplanes
•
setting up of a new business
•
modernisation of an existing asset, eg a computer system, or a business
•
redevelopment of an existing asset, eg a property.
New projects undertaken by a company, requiring significant resources more than the
normal budget, will be subject to cost justification to show that the expected benefits
exceed costs.
When the costs exceed the benefits for more than a short time, a mechanism to Incorporate
the time value of money Is needed. This will consider the value of any project or how
alternative projects compare.
Capital will be needed to finance these projects and there will be a cost In supporting that
capital. The cost of capital is a measure of this cost expressed as an annual rate of interest.
The cost of capital shows the price at which investors are willing to buy in to the risks (and
returns) that the company offers. The determination of a suitable required rate of return for a
project based on the cost of capital is discussed in detail in the next chapter. We shall see that
the discount rate chosen should reflect the systematic risk of the proj ect.
f ;~
Question
Entrepreneur A approaches the bank with a low-risk business proposal and is offered finance at
10% pa for the project. Entrepreneur B approaches the bank with a different project and is
offered finance at 15% pa for th e project.
Explain what this might indicate about the two projects.
CBl-19: capital project appraisal (1)
Pages
Solution
It is probably not the case that Entrepreneur B has failed to sell themselves as well as
Entrepreneur A or that the bank are simply looking for 50% extra return from B compared with A.
More likely, the bank perceives B's project as carrying higher risks, either of complete failure/
default or of not achieving the stated returns, so the bank charges a higher interest rate to
compensate for the risks.
1.2
Initial appraisal
Before proceeding with a full-scale time-consuming and costly detailed project appraisal, the
company's project analysts will usually undertake a quick initial appraisal.
The main purpose of the Initial appraisal of a proposed capital project Is to decide whether
the project will satisfy the criteria set by the sponsoring organisation that authorises the
project.
If not, it is not worth carrying out a detailed appraisal.
The sponsoring organisation may have a single set of predetermined criteria or the criteria may be
varied according to the particular project concerned, eg a 'low-risk' project might be required to
produce an internal rate of return of 10% pa compared to 20% pa for a 'high-risk' project.
f
I Question
V:
Explain the possible meaning of 'high-risk' and 'low-risk' in the above statement.
Solution
Most projects can be analysed in terms of cash inflows and cash outflows.
A high-risk project might be one in which the cashflows cannot be predicted with any degree of
certainty. The graph of NPV (on the x-axis) against the probability of outcomes (y-axis) would
show a wide range of outcomes for the project.
A low-risk project might show a narrow spread of results with a high certainty of a profitable
outcome.
CBl-19: Capital project appraisal (1)
Page 6
These criteria wlll describe the financial results expected and (sometimes) the risk that
these results may not be achieved. However, there may be many additional criteria In
practice, Including:
•
achieving synergy or compatibility with other projects undertaken by the sponsor
For example, developing a new product that can be sold in conjunction with an existing
product.
•
satisfying 'political constraints', both within and without the sponsoring
organisation.
The project may not be acceptable or even desirable in the eyes of senior management
who may need to give approval before the project can proceed.
•
having sufficient upside potential
•
using scarce investment funds or management resources in the best way.
Although the particular project may appear profitable, there may be other even more
profitable projects or uses for the available funds.
In other words, the main criteria by which to judge the attractiveness of the project are the usual
ones of risk and expected return, together with an assessment of how far the project is likely to
satisfy any other objectives that the investor might wish to achieve.
Consider how well the project fits into the overall project portfolio and whether there are any
synergies eg in the form of reduced average costs, once these are spread across other projects.
During the appraisal process it will be necessary to investigate the main risks involved in
the project and come to a view on the best course of risk mitigation, having regard to the
costs involved.
The remaining risks will need to be listed for the benefit of sponsors, lenders and Investors,
so that they can be considered In the decision-making process.
We will discuss the analysis and mitigation of specific risks in detail in the next chapter.
Detailed analysis is an expensive process, so the complex evaluations are conducted only
once it is clear that the effort is justified.
As the proj ect looks more likely to proceed, the financial modelling becomes increasingly complex
and sophisticated, so as to generate more accurate projections of the likely financial outcomes of
the project, eg for tax, risk and the sensitivity of cashflows to different economic scenarios.
In thi s way, the level of uncertainty attaching to the appraisal is reduced.
1.3
Definition of project
The first step is to define the project and its scope carefully and to assess its likely length of
operating life.
The definition and scope of the project must be unambiguously set out and agreed by the various
parties involved and should include careful reference to any interactions with existing projects.
The length of the project might itself be one of the criteria by which it is judged.
CBl-19 : capital project appraisa l (1)
Page 7
The scope of a project might include:
•
the specific objectives of the project
•
the principal activities in each stage of the project, eg construction of asset, use of asset
•
the aims, scope and timing of investment and the stages of the investment cycle
•
the success criteria of the project, eg a positive NPV based on 12% pa
•
to whom (or which departments) the goals of the project apply (and who is not affected)
•
the exact responsibilities of the various people in the project team
•
time limits beyond which the project team's responsibilities and powers will not extend
•
a list of connected issues for which the project team is not responsible.
It is hard to generalise, however the failure of many projects occurs because the scope of the
project was not specified clearly enough. Consequently during the project, the individual goals
and responsibilities may become unclear and confused and the project will fail to meet its targets.
1.4
Evaluation of cashflows
There should then be an evaluation of the most likely cashflows for:
•
capital expenditure
•
running costs
•
revenues
•
termination costs.
This will often be based upon the best point estimates of each of the main cashflows involved.
These cashflows should be expressed in terms of present day money values and should
exclude financing costs such as interest, depreciation, effects of price inflation, etc.
However, if any of the cashflows are expected to increase in real terms (eg in line with
wages rather than prices), this must be considered.
The initial appraisal is usually based upon real values for the cashflows - the cashflows perhaps
being easier to interpret if expressed in present-day money values - discounted using appropriate
risk-adjusted real discount rates.
The cashflows should allow for any effects on the sponsor's other activities or costs .
Again any interactions or synergies with existing projects must be allowed for appropriately,
eg sharing of costs, by-products or spin-offs.
Accurate definition and evaluation of the most likely cashflows is crucial to the success of
the subsequent work, as these constitute a baseline.
Great care must be taken, with all the assumptions made being carefully documented.
Page 8
CBl- 19: Capital project appraisal (1)
f1
_Q_u_e_s_t_
io_n_____________________________
A software company is assessing whether or not to develop a 'second generation' financial
modelling package for insurance companies.
Suggest a possible synergy that might be considered by the software company as part of its
project appraisal process.
Solution
A potentially beneficial synergy is that companies who buy this new financial modelling package
might also buy other modelling packages from the software company in the future.
On the other hand, sales of this new financial modelling package might simply replace sales of the
software company's existing 'first generation' financial modelling package.
Both of these possibilities would need to be allowed for in the project appraisal.
Candidates are expected to be able to carry out simple cashflow projections and use
techniques to estimate cashflows. Details of the methods are covered In Subject CM1.
CBl-19: capital project appraisal {1)
2
Page9
Methods of project evaluation
Using cashflow projections, the next step is to make an initial evaluation of the likely
financial result of the project. A discounted cashflow approach is normally used.
2.1
Net present value (NPV)
The NPV method models all the cashflows of a project until completion and discounts these
back to the present day using the cost of capital.
NPV uses a discounted cashflow (DCF) approach to project evaluation.
If the result is positive, then the project will improve shareholder returns.
If the NPV is positive when discounted at the Weighted Average Cost of Capital (WACC), then the
project earns a rate of return greater than the WACC, so earns a return greater than the
opportunity cost of the funds provided by the shareholders and debtholders.
The company can allow for risk within the NPV method.
Risk is best allowed for in the model explicitly so that the company will look at the weighted
average NPV of a range of scenarios.
The company would need to bear In mind Its risk tolerance In deciding how to finance the
project. The discount rate used could be different for different types of project.
A high discount or hurdle rate might be used for projects that are deemed to have a high degree
of systematic risk. In addition, we will see below that companies may deliberately use high hurdle
rates in order to identify those projects that are particularly profitable . If this is the case then it
does not mean that a project is loss-making simply because it fails to meet the hurdle rate. It
simply means that the project is not as profitable as it needs to be to meet the company's criteria .
We will discuss the determination of the required rate of return for a project in the next chapter.
iJ
Question
Wrong Turn Ltd is analysing two projects, the first of which (Project A) gives the following
estimated cashflows at the end of each of the coming years):
Time in years
0
1
2
Cashflow (in $ millions)
(4)
2
4
The second project (Project B) gives the following cashflows:
Time in years
0
1
2
Cashflow (in $ millions)
(2)
15
(14)
Assuming that the company sets a hurdle rate of 20% pa for its projects, determine which of the
above projects pass the test.
CBl-19: Capital proj ect appraisal (1)
Page 10
Solution
Both! At 20% the NPV of Project A is:
2
4
(1 +0.2)
(1 + 0.2)2
15
14
(1+0.2)
(1+0.2)2
NPVA = - 4 + - - - + - - - = 0.44
and of Project B is:
NPVs =-2+
Ifill
= 0.78
Question
On further analysis of Project A, WrongTurn finds that the risk involved in the cashflows comes
primarily from one source of uncertainty, which it analyses further. The cashflow at the end of
Year 2 has a high risk of not materialising. In fact there is a 25% chance that the cashflow will
simply not happen, and a 75% chance that it will be earned.
The company wishes to analyse Proj ect A using its cost of capital (15% pa) rather than an
arbitrarily high hurdle rate of 20% pa . Determine a revised NPV in this situation.
Solution
By allowing more precisely for the final cashflow, it can be determined that the expected value of
the payment would be 0.25 x O + 0.75 x 4 = 3. Reworking the equation with a final payment of 3
and a discount rate of 15% pa gives:
NPV
= -4+
2
(1 + 0.15)
+
3
(1 + 0.15)2
= 0.008
ie the project satisfies the requirement Uust!).
Some companies take a more relaxed view for small expenditures and demand a higher rate
for large expenditures.
2.2
Internal rate of return (IRR)
()
This is essentially the same in method of calculation as the NPV, the difference being that
rather than discounting at the cost of capital, a solution Is found for the Interest rate that
gives the project a zero NPV.
-
The method has the benefit of highlighting the return achieved by the project.
If this is higher than the cost of capita!, than the project may proceed.
If a project ha s an IRR which does not satisfy the company's criteria, this does not mean that the
project is loss-making. It simply means that it is not profitable enough to satisfy the minimum
requirements (eg a cost of capital requirement) set by t he company.
CBl-19 : capital project appraisal (1)
Page 11
However there are practical problems with the IRR approach:
1.
Nonsense results can be obtained if the initial capital is small, giving very high
positive (or negative) solutions, two solutions or no solution at all.
2.
While the average net present value of a range of scenarios can be found simply by
summing the value multiplied by the probability of the scenario, this is not the case
for the internal rate of return.
3.
It should be noted that the IRR equation can sometimes have multiple solutions,
especially If there are net negative cashflows at some points during the operating
life of the project or at completion. This has helped to make It less popular than the
NPV as a measure of project worth.
Despite these problems, the internal rate of return can provide a single convenient tool.
One main advantage of the IRR is that it provides a rate of return for the project. As such it is
intuitively easy to understand for non-experts.
(iiJ Question
Determine the internal rate of return for Projects A and B.
Solution
We are looking for iA, and is respectively in the following:
2
4
NPVA = - 4 + - - + - - = 0
(1 + iA) (1 + iA)2
NPV8 = - 2 + ~
(1 + is)
14
(1 + ia)2
=0
The most sensible answers are iA = 28.0% and is= 9.2%. However, Project B has a negative net
cashflow during the life of the project, and there is an alternative solution is= 540%.
2.3
Annual capital charge
·o-
This method expresses the capital outlay as an annual charge, writing off the capital
steadily over a period of years. This charge may then be offset against the benefits, and if
the net result is positive, the project or capital expenditure can be approved.
This method Is valuable since It shows the Impact on the company's profit stream of an
Investment. The short-term Impact on earnings may be highly sensitive, as It Is very vlslble.
The annual capital charge is simi lar to the depreciation charged through the balance sheet.
The initial capital expenditure is amortised over a specified period and offset against the profits
from the project as they accrue.
CBl-19: Capital project appraisal (1)
Page 12
There are then a number of ways of using the resulting net earnings figures, they can be:
•
simply accumulated to establish the year in which the project moves in to profit
•
added to the company's other forecast earnings to see the overall impact on the reported
figures, useful if the other earnings are depreciated on a consistent basis.
This method works well looking at capital expenditure on machinery or plant and benefits
from being simple and easily understood. It should not be ruled out just because there are
more complex methods available.
fiJ
Question
Project D involves an initial investment of 10. It is estimated that the project will generate
subsequent cashflows of +3, +3½, +4 and +4 at times t= 1, 2, 3, 4. Calculate the net cashflows
after allowing for an annual capital charge using a 4-year amortisation period.
Solution
Writing off the 10 initial investment over a 4-year period, implies an annual capital charge of 2½.
So the net cashflows after the annual capital charge are+½, +1, +1½ and +1½ at times 1, 2, 3, 4.
2.4
Shareholder value approach
Shareholder value represents the present value of all expected current and future cashflows
available to shareholders.
The shareholder value method is based on but extends the NPV approach. The method has
the important distinction that it is looking at the company from the point of the external
shareholder and less on the Internal issues governing the attractiveness of a project
The way the method works conceptually Is very simple. The total value of the company Is
examined on a 'before and after' basis.
The way the company Is valued currently by the market needs to be understood.
This is where the human element comes in. It is very difficult to say what 'investors' in general
are looking for in a company's shares.
Depending on the sector, price earnings ratios or price to net asset ratios may give an
indication of how a company stands In relation to Its competitors. Comparison of key
figures such as these with competitors will help determine a company's standing In the
market.
The difference in rating Is the value being placed by the market on the management's ability
to grow the business profitably. If they have high confidence, then the capitalisation of the
company will be high in relation to its peers.
We looked at ratio analysis in more detail in earlier chapters. Amongst the most important ratios
with regard to shareholder value are the price earnings ratio and the dividend yield.
Page 13
CBl-19: Capital project appraisal {1)
t . ,~
Question
Company A and Company Bare quoted in the same industrial sector. The following observations
can be made of the two companies:
CompanyA
Current market price
Historical dividend
Historical earnings per share
200p
lOp
20p
CompanyB
300p
20p
35p
A financial analyst in Company A is considering using the 'shareholder value' method to assess a
project and is wondering what the above information indicates about how the market perceives
the company relative to its competitors.
(i)
Analyse the two companies based on the data above.
(ii)
Give reasons why the above analysis might be tenuous.
Solution
(i)
Tentative analysis
Dividend yield
PE Ratio
(= _p_ri_ce_p_er_sh_a_r_e_)
earning per share
Company A
CompanyB
5%
6.7%
10
8.6
In general investors rate Company A more highly than Company Bas they are willing to pay a
higher multiple of its historical earnings to buy the share. The higher dividend yield for
Company Bis simply a factor of its higher payout ratio, ie Company B pays a higher proportion of
its earnings in dividends.
Company A is regarded more highly by investors, perhaps because they see greater potential in
Company A.
Company A must demonstrate this potential in profitable projects. If a project earned the same
return in Company A as it did in Company B this would cause the market to think that they had
overestimated the potential of Company A.
(ii)
Reasons why the analysis might be tenuous
Possible reasons include:
1.
although the compani es are in the same sector, they may not be directly comparable
2.
the historical earnings and dividends may be affected by one-off factors
3.
the companies may be valued by investors on various other grounds that are not
mentioned in the question, eg market share, brand recognition, etc.
CBl-19: capit al project apprai sal (1)
Page 14
The value-added approach then adds in the new project or company purchase and looks at
all the valuation Issues above to see what the Impact Is. The Impact on net asset value,
future earnings and debt cover may all be calculated relatively easily by adding In to the
company model the cashflow scenarios developed for the NPV method.
The Important element of the value-added process now comes Into action, for It has to look
at the Impact of the new project on the rating of the company.
Issues to be evaluated would Include:
•
impact on ranking versus competitors
•
possible competitor reactions and change in level of competition
•
Impact on perception of management
•
impact on analyst perceptions
•
impact on debt rating
•
enhancement or dilution of earnings
•
impact on dividend policy
•
impact on stock beta.
The addition of a new project to the business could have an impact on the whole way the
business Is perceived and so fundamentally alter the share rating. The value added
approach tries to look dispassionately at the before and after positions and the result
measured Is the Increase In value of the shares to the current Investors.
This is clearly a subjective decision, as many business decisions are.
However, the method has the advantage of allowing numerate managers to mix the rigorous
financial calculations and cashflow projections with the uncertainties of the market, and emerge
with a decision that fits with the strategic direction of the company and adds shareholder value.
The shareholder value added approach has exciting possibilities for actuaries; it is complex
and benefits from careful mathematical modelling of the interactions and feedback loops to
ensure all the possible consequences of the project have been considered.
It offers the opportunity for exciting new policies that are likely to be well received by the
stock market to be adopted. These projects might have been overlooked if evaluation was
carried out on a narrow basis, looking only at the project itself.
The disadvantage of such a method is that it involves rating the project on a number of different
criteria, some of which may be perceived as more important and some less. When debating the
pros and cons of a number of projects, there may be no clear w inner or loser. It may be a matter
for discussion which factors should be rated most highly in the analysis.
In addition, the stockmarket itself is prone to changing its focus regularly. Companies that are
valued on the basis of net asset value one year, suddenly become valued on their prospects for
growth the next.
2.5
Payback period
In many small companies It Is cashflow that Is crucial and so the speed at which a project
can recoup its initial investment is vital.
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Page 15
For a small fast-growing company that will find It hard to raise debt and whose shareholders
are already stretched, payback becomes the crucial factor.
Q The payback period Is defined as the time It takes for the accumulated cashflow to become
-
neutral.
The project with the faster payback period will be preferred. Alternatively, the method can
be used to Identify the project that generates the most funds over a specific period, say
three years.
The method Is of relatively little value where payback terms are over three years.
This is because it does not allow for discounting.
Nevertheless, in view of its simplicity it continues to be a popular method.
lmJ Question
The table below describes the expected cash inflows and outflows in respect of a project.
Time in years
0
1
2
3
4
5
Cashflow ($ millions)
(4)
(3)
2
4
3
2
Cumulative cashflows
(4)
(7)
(5)
{1)
2
4
Determine the payback period.
Solution
The payback period is found by looking at the cumulative cashflows, and estimating the time at
which it changes from negative to positive.
This looks to happen around one third of the way through Year 4. So the payback period is about
3.33 years, assuming continuous cashflows.
1
I Question
t / ( - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -Describe circumstances in which the payback method might be applicable.
Solution
Payback period would be applicable when the :
•
size of the project does not warrant deeper analysis, eg discounted cashflow techniques
•
hurdle rate is low enough such that discounting has little impact
•
project occurs over a short period where discounting is not warranted and would make
little impact
•
cashflows themselves are so uncertain that discounting introduces spurious accuracy.
Page 16
2.6
0
-
CBl- 19: Capital project appraisal (1)
Nominal returns
This is a variant of the payback period where one simply compares the ratio of cash
generated to cash consumed over a period.
It can give a quick Idea of the relative profitability of projects and is an adequate approach
where the ratio can quickly be seen to be high.
Again, the term over which such an evaluation is made should be short.
IfiiI
Question
Calculate the nominal return over a four-year period of the project on the previous page.
Solution
9
The nominal return over a four-year period is --1= 28.6%.
7
The method is normally used (and is better suited) to projects that involve a single cash outflow in
the first year and an inflow in subsequent years.
2.7
Strategic fit
Strategic flt will normally form a part of every project evaluation as every project should fit
logically with the business, building on Its areas of expertise, resources or customer base.
Sometimes a new departure into a business sector cannot be justified on purely financial
grounds, but it is being taken because of a view being taken on the way the industry is
moving.
Often projects cannot be analysed on financial grounds, and can only be subject to qualitative
analysis.
There are parallels with the methods outlined when a range of scenarios Is considered. The
difference here Is that a particular future business scenario Is identified, and a business
response developed, on the assumption that this future projection holds good. Such an
investment can reap huge rewards if the future goes as predicted and there are
opportunities to be gained by being ahead of the pack. If things do not tum out as expected
however, the project has to be carefully monitored to limit the potential downside.
Of course most projects can be analysed using projected cashflows, and one can take the view
that the investment must justify itself.
Over the last ten years, the insurance industry has seen massive changes in distribution
methods and many of the investments made could only be justified on strategic grounds.
Even the changes to insurance product distribution networks may be justified if one looks
sufficiently long term, and is willing to make the assumptions that are required.
CBl-19: Capital project appraisal (1)
Page 17
However, when the parameters become more 'guesswork' than science, and the variability of the
inputs becomes too high, it is often better to accept that it is a purely subjective decision, and
make the decision on that basis.
If a business makes the right investment decision then the required return comes as a byproduct and Is not the deciding factor.
There Is scope for actuaries to develop more sophisticated models that build In expllcltly
these 'difficult to quantify' benefits. Indeed, any project may bring with it intangible benefits
that It may be possible to value if sufficient thought Is given to the exercise.
2.8
Opportunity cost
It is all too easy to put up a project that may satisfy the business criteria for acceptance but
may not actually be the best way of proceeding. There may be some alternative opportunity
that is even better that has not been considered.
Q The opportunity cost method asks 'What alternative ways could we spend this money and
-
what return would be achieved?'
Thus, even if a project does satisfy the criteria applied by the company it might not be the best
opportunity available to the company.
A key criteria required that the project be the best use of scarce management time and resources.
It is therefore always worth looking at all the available projects before making a decision, and
choosing the one that best satisfies the financial and qualitative criteria.
Apart from this method proving useful to help identify better alternatives, it can also on
occasion justify spending when there is surplus capital that cannot for some reason be
invested to earn the cost of capital return.
It may be in the company's interest to invest in this project provided that it yields a better
return than alternatives with a similar risk profile, even if under the true cost of capital.
It is often the case that a company will identify a project it believes would strengthen its position
in the industry. However it cannot justify the expenditure using a cost of capital analysis.
If the company has capital available to invest, it has two options:
1.
reject the project and keep searching for projects that do satisfy the IRR requirement
2.
test the rejected project using a lower cost of capital.
The company must consider the return it will get if it rejects the project but can find no other
project to invest in and therefore invests the surplus cash in the money markets. If the IRR of the
project is higher than money market returns, then it might be better to undertake the project
than to simply leave the funds invested in money market deposits.
If the management decide that there is a risk that an alternative will not be found quickly, and
that the money will lie idle for some time, it may be that the opportunity cost of not undertaking
the initial project is large. They should begin a project as an alternative to investing in the money
market.
CBl- 19: Capital project appraisal (1)
Page 18
It should be remembered that returning capital to shareholders Is an option, but there are
frictional costs if the company finds itself wanting to raise new capital at some future point.
~ Question
:l:
Li
Explain how a company might return funds to shareholders.
Solution
It might use share or stock buybacks, or alternatively simply pay a much larger dividend.
It is also possible for companies to pay an exceptional dividend to shareholders, however the taxinefficiency of this route means that it is seldom followed.
This is not really a new method as all the items could be incorporated in the main methods;
it is the focus of attention on alternatives that is the difference.
2.9
Hurdle rates
Again, this Is not a new method but can be Incorporated In the methods above.
Q The emphasis Is that the company sets a target rate of return, or a hurdle rate. This could
-
typically be quite high and well In excess of the true cost of capital.
For example, a company might set a target return on capital of 20% in order to concentrate
minds on only the most profitable projects. Only projects with a positive NPV discounted at
20% or an IRR in excess of 20% would get past the first screening.
In reality, the project champion Is likely to emphasise the potential upside to demonstrate
the high return, understating the risk. The actual achieved return on accepted projects Is
therefore liable to come in well below the business plan.
The approach has the advantage of exposing the high potential projects which, if managed
well, will bring in high returns. The flip side is that many excellent low-risk projects that
would deliver good returns above the cost of capital (but below the hurdle rate) will never be
considered.
If a company intends to look only at projects that deliver returns in excess of 20% it will accept:
•
extremely high-risk projects, which may, if successful, give a superior return
•
projects presented by over-ambitious project managers who dearly want their project to
get the go-ahead and underestimate the risks and overstate the returns.
The rates actually being used by companies of different sizes have been surveyed. This
showed an average IRR hurdle rate of 17.1%, which Is very high compared with the longtenn achieved returns on equity.
L
I Question
t ,,r -------------------------------Explain why the use of high hurdle rates is common in industry.
CBl-19: Capital project apprai sa l (1)
Page 19
Solution
•
They are simple to compute and understand.
•
Often the uncertainties in a project can best be modelled by a simple (say) 5% pa
compound probability (cashflows at the end of the first year have a 0.95 chance of
occurring, in year two they have a 0.952 chance of happening, etc). In such circumstances
a high hurdle rate (say 20%) can be viewed and justified as a 15% cost of capital rate and a
5% uncertainty rate.
•
Companies often have more than sufficient projects to be getting on with. If a new
project is accepted, using valuable scarce resources, it has to be a really profitable one.
2.10 Receipts/costs ratio
Another measure, which is not often employed but which can sometimes be useful is the
receipts/costs ratio, defined as:
NPV of the gross revenues
NPV of the capital and running costs
This indicates the level of profit as a proportion of costs and is therefore related, but different, to
the concept of the profit margin encountered in the financial analysis of companies.
The denomi nator includes the capital costs as well as the project costs.
Page 20
3
Results of the evaluation
3.1
Initial result
CBl- 19: Capital project appraisal (1)
The result of an NPV calculation would usually be regarded as satisfactory if it was positive.
The result of an IRR calculation would be regarded as satisfactory if it exceeded a
predetermined 'hurdle rate' set by the sponsor.
The payback period would be regarded as satisfactory If it was less than a predetermined
period set by the sponsor.
The choice of the discount rate used with the NPV or the hurdle rate with which the IRR is
compared is therefore crucial - likewise the choice of payback period.
tr
Question
Explain why the choice of the discount rate used with the NPV is so important.
Solution
If the negative cashflows associated with a project mostly precede the positive cashflows, then
the use of too high a discount rate will lead to the rejection of some projects that are actually
likely to be profitable when assessed against an appropriate discount rate.
In addition, if the high return projects tend to be riskier, then this will lead to the acceptance of
too many risky projects.
It may also lead to more short-term projects, as long-term cashflows will be 'over-discounted'.
The results of these calculations will provide a crude initial appraisal of the financial
viability of the project.
However, there are a number of simulation techniques that can be used to obtain a fuller
understanding of the viability of the project.
3.2
Simulation
Sensitivity analysis
Q Having modelled the project for the purposes of evaluation, we may wish to apply
-
sensitivity analysis to see how the value of the project changes with differing future
conditions.
We take each key assumption in turn and assess the effect on NPV of the most optimistic
and pessimistic results occurring.
A broad Idea of the sensitivity of the results to varying assumptions can be obtained by
assuming that all the costs are, for example, say 10% higher than the most likely values and
all the revenues are, for example, say 10% worse than the most likely values.
CBl-19: Capital project appraisal (1)
Page 21
In sensitivity analysis, we take each key assumption in turn in order to understand the impact of
each individual assumption.
In this way, we can Identify which are the variables that have the greatest effect on the
outcome of the project, thereby determining where more Information Is needed (and when
forecasts are inappropriate, confused or inconsistent).
For example, a company could sensitivity test a project as follows. Having completed the central
NPV estimate for the project, it might wish to test the sensitivity to the key assumptions - for
example inflation, consumer spending and materials costs.
Inflation
Consumer spending
Materials costs
Low
High
Low
High
Low
High
Assumption
Less 2%
Plus 2%
Less 2%
Plus 2%
Less 2%
Plus 2%
Net effect on NPV $m
-1.5
3.2
-6.2
4.5
2.5
-8.9
The results shown in the table above demonstrate that the project would benefit from higher
inflation and higher consumer spending, but that the key exposure on the downside is an
increased cost of materials.
The results demonstrate how the profitability is affected by movements in the underlying
parameters. However, the results give no indication of the interaction between the variables,
eg an increased cost of materials may occur at times of high inflation, but no indication is given of
this.
Scenario testing
However, sensitivity analysis does not allow us to consider the interrelationships between
input variables.
To do this, we need to employ scenario testing, where we consider some plausible
combinations of input values and see what effect these have on the project.
Scenario testing involves choosing particular scenarios or combinations of factors to which the
project or institution may be exposed. The effect of the combination of events is then modelled
and investigated, showing the overall resulting financial gain or loss for the company.
For the above project, the results of a scenario test might look like this:
Scenario
Gain/(Lossl
Inflation+ 2%, cons spending+ 2%, materials+ 2%
-st.Sm
Inflation - 2%, cons spending+ 2%, materials - 2%
+S4.lm
etc
CBl-19: Capital project appraisal (1)
Page 22
These scenarios can be chosen to show, for example:
•
combinations of events to which profitability is highly exposed.
•
circumstances that the company management believe are highly likely to occur
•
the implications of further exposure to the same particular scenarios to which the
company is already exposed through existing projects.
But even scenario testing will involve a limited number of plausible combinations, which
may or may not include the most optimistic and pessimistic values. To consider a//
possible combinations we need to use (Monte Carlo) simulation.
Monte Carlo simulation
Q Here we look at the entire distribution of possible project outcomes.
-
In order to do this we need to:
•
model the project (usually on a computer), allowing for Interdependencies and serial
correlations
•
specify probabilities for the distribution of the key variables (possibly investigated
by the use of sensitivity testing)
•
simulate the cashflows many times using values extracted randomly from the
distributions of possible variable inputs
•
record and order the outputs to assess their probability distributions.
This process is critically dependent on:
•
appropriate model design
•
appropriate assessment of the probability distribution of the inputs.
The former is a problem when the model builder is not experienced in the field being
modelled.
Monte Carlo simulation involves creating a model, into which all the variabilities and correlations
of the input criteria are entered. The model then runs a large number of simulations to obtain a
spread of results. The resulting chart may look as follows.
Figure 1: Results of Monte carlo simulations
20
~
Q)
E
15
0
u
...,
:::,
.....00 10
..
. .
>
...,
:c
ro
5
..c
...0
0..
0
IO
I
I/')
I
"-I"
I
mI
N
I
.-1
I
0
.-1
N
Project NPV in£ millions
m
"-I"
I/')
IO
CBl- 19: Capital proj ect apprai sa l (1)
Page 23
From the chart we can identify the mean profit, the spread around that mean, and the shape of
the profitability chart, which here appears to be negatively skewed (due to the long lower tail).
Financial modelling software can be purchased that has been specifically designed for carrying out
Monte Carlo simulation. Indeed, many models, each specific to a particular sector of a particular
industry, have been designed.
1
I Question
t /f --------------------------------Set out the main advantages and disadvantages of performing a Monte Carlo simulation as part of
a project appraisal.
Solution
Advantages include:
•
increased understanding of the project parameters
•
greater information on the range of results, not just the mean but also the spread and the
shape of the distribution of such outcomes (eg fat-tailed, skewed, etc)
•
identification of outliers - eg events with negative NPVs.
Disadvantages include:
•
increased workload, which might not be justifiable
•
spurious accuracy
•
errors caused by the complexity, leading to a wrong result.
Scenario testing and Monte Carlo simulation are complex and therefore expensive. They are
unlikely to be performed at an early stage in the project appraisal process.
Although It may appear that the stochastic simulation method would be superior, practical
experience has shown that the results from a stochastic model cannot always be relied
upon with sufficient confidence to justify the effort and expense involved.
More seriously, there is the danger of losing sight of key factors and assumptions in
looking at the output from such a model. Instead, the effort of working up a scenario
analysis by hand often forces the analyst to concentrate on the important risks and
assumptions.
Despite this, however, a comparatively simple stochastic model may be useful to simulate
one specific project activity, where the assumptions underlying the model, and its
limitations, can be kept clearly in view.
3.3
Results of the analysis
The results obtained might, If very unsatisfactory, suggest that further analysis Is not
worthwhile without some fundamental redesign of the project.
If, however, the results appear satisfactory, it is not sufficient to stop there, and a proper
risk analysis should be undertaken as indicated in the next chapter.
Page 24
3.4
CB1-19: Capital project appraisal (1)
A note about tax
In the initial stages of the analysis, It will usually be sensible to exclude the negative
cashflows resulting from corporation tax, since these will depend (among other things) on
the method of finance adopted and It Is an unnecessary complication to rework the tax
every time the NPV is reworked during the analysis.
At the final stage, when the Investment submission is being prepared, the negative
cashflows arising In respect of corporation tax can be evaluated (allowing for appropriate
tlmelags In the collection of the tax) and discounted In order to arrive at a suitable
deduction from the NPV.
In practice we will be interested in the NPV of a project net of any tax payments, or equally the
net-of-tax IRR.
Successive iterations of the appraisal process can introduce more complex and hence realistic
modelling of the project.
CBl-19: Capital project appraisal (1)
Page 25
Chapter 19 Summary
Capital project appraisal
A capital project involves an initial expenditure and then, once the project comes into
operation, a stream of revenues less running costs.
An initial appraisal assesses whether the project is likely to satisfy the sponsors criteria, eg:
•
the financial results expected and risk these results may not be achieved
•
achieving synergy or compatibility with other projects undertaken by the sponsor
•
satisfying 'political constraints', both within and without the sponsoring organisation
•
having sufficient upside potential
•
using scarce investment funds or management resources in the best way.
The first step of the appraisal is to define the project and its scope carefully and to assess its
likely length of operating life for the purpose of the appraisal.
There should then be an evaluation of the most likely cashflows, expressed in terms of
present values, for capital expenditure, running costs, revenues and termination costs.
Methods of project evaluation
The net present value (NPV) method models all the cashflows of a project until completion
and discounts these back to the present day using the cost of capital. A positive result
indicates that the project will improve shareholder returns.
The internal rate of return (IRR) is the interest rate that gives the project a zero NPV. This is
compared with the cost of capital.
The annual capital charge expresses the capital outlay as an annual charge, thus writing off
the capital steadily over time . This charge may then be offset against the benefits.
The shareholder value approach attempts to assess the impact of the project on the value of
the company as a whole from the point of view of shareholders.
The payback period measures the time it takes for the accumulated cashflow from the
project to become neutral.
CBl-19: Capital project appraisal (1)
Page 26
Nominal returns compares the ratio of cash generated to cash consumed over a period.
Strategic fit assesses how the project fits in with the rest of the company's business, building
on its areas of expertise, resources or customer base.
The opportunity cost method asks 'What alternative ways could we spend this money and
what return would be achieved?'
Companies sometimes assess the profitability of a project against a hurdle rate of return,
wh ich could be quite high and well in excess of the cost of capital.
.
. .
NPV of the gross revenues
The receipts/costs ratio 1s defined as - - - - - - - - - - - NPV of the capital and running costs
Results of the evaluation
The result of an NPV calculation would usually be regarded as satisfactory if it was positive.
The result of an IRR calculation would be regarded as satisfactory if it exceeded a
predetermined 'hurdle rate' set by the sponsor.
The payback period would be regarded as satisfactory if it was less than a predetermined
period set by the sponsor.
These results offer a crude initial appraisal of a project. To gain a fuller understanding of the
viability of a project, simulation techniques can be used:
•
Sensitivity analysis takes each key assumption in turn and assesses the effect on the
NPV of the most optimistic and pessimistic results occurring.
•
Scenario testing involves changing plausible combinations of input values and seeing
what effect these have on the project.
•
Monte Carlo simulation attempts to look at the entire distribution of possible project
outcomes via numerical simulation. It is critically dependent on an appropriate
model design and appropriate assessment of the probability distribution of the
inputs.
If the results from an initial cashflow analysis are very unsatisfactory, then further analysis is
unlikely to be worthwhile without some fundamental redesign of the project. If, however,
the results appear satisfactory, then a proper risk analysis should take place.
The analysis is usually refined to allow for complications such as corporation tax only at its
later stages.
CBl-19 : capit al project appraisal (1)
Page 27
~~ Chapter 19 Practice Questions
19.1
Exam style
A key difference between the net present value technique and the internal rate of return
technique for capital budgeting is that :
A
19.2
the net present value is easier to calculate.
B
they use different cashflows.
C
D
they have different reinvestment rate assumptions.
they use different time periods.
Outline the drawbacks of the payback period method of project appraisal and suggest
circumstances under which it might be an appropriate method to use to evaluate a project.
19.3
Exam styte
19.4
The payback method can lead to the wrong decision being made because:
A
it ignores income beyond the payback period.
B
the payback period is difficult to calculate.
C
D
the returns in later years are uncertain.
of the emphasis placed on the interest factor.
Company D uses a 'hurdle rate' to appraise investment projects.
(i)
Explain what is meant by a 'hurdle rate', commenting on its usefulness.
Company Dis considering two projects. They are identical, except that one is based in a foreign
country and the profits will accrue in a foreign currency.
(ii)
19.S
Explain which would be more likely to pass the 'hurdle' test.
Company G has prepared the following table giving the expected net present values for a large
project which is under consideration.
Net present values of project using a discount rate of 10%
2%
Inflation estimate
Duration of construction phase
6%
3 yrs
5 yrs
3 yrs
Syrs
Labour costs
low
high
low
high
low
high
low
high
Expected NPV (in $ millions)
2
0
(1)
(3)
4
2
2
0
(i)
Explain the benefit of the above analysis over a single estimate of the NPV.
(ii)
Describe the weaknesses of the above approach.
(iii)
Explain how the technique above could be improved.
CBl-19: Capital project appraisa l (1)
Page 28
19.6
Exam style
Which of the following is NOT a valid reason for using simulation in order to evaluate an
investment project?
A
B
C
D
19.7
Exam style
The cashflows are uncertain.
The required rate of return might vary during the life of the project.
Decision makers are interested in the range of possible outcomes.
Decision makers require an accurate forecast.
A company is evaluating a potential project using Monte Carlo simulation with a very large
number of iterations. The results show a positive net present value for 85% of the simulations.
The results suggest that there is a 15% chance that the project will make a loss.
II
The results suggest the expected net present value of the project is positive.
Ill
The results suggest that the project should go ahead .
Which of the statements is/are true?
A
B
C
D
I only
II only
I and II only
II and Ill only
CBl- 19: Capital project appraisal (1)
•
Chapter 19 Solutions
19.1
Answer= A
r--,
Page 29
Both methods use the same cashflows and there is no reinvestment assumed in either NPV or IRR
calculations. They do not use different time periods.
19.2
The drawbacks of the payback period method are:
•
the method is simplistic
•
no account is taken of the real value of money (not 'discounted payback')
•
no account is taken of the cashflows after the end of the payback period
•
no measure of return is given to allow the user to com pare with other projects
•
no measure of net present value is generated to allow the user to make a comparison of
the size of the project relative to other projects.
Its use may be appropriate in situations where either:
•
a simple method is required, eg because the project is extremely small and does not
warrant further analysis
•
the time horizon is very short and discounting will not affect the overall result to any great
extent
19.3
•
the quality of the data does not warrant detailed analysis
•
the company would be at risk if cashflows were negative for an extended period
•
resources are scarce, and do not permit further analysis.
Answer= A
Both the NPV method and the IRR method consider all cashflows throughout the life of the
project, but the payback method only considers cashflows up until the end of the payback period.
The payback period is easy to calculate. There is no discounting so the interest rate has no role.
The fact that future cashflows are uncertain is less of a problem for the payback period method
than it is for the NPV and IRR methods, since the payback period is less likely to use cashflows
further into the future.
19.4
(i)
The hurdle rate
The hurdle rate is a discount rate set by management as a target rate of return. Any projects
considered by the company must demonstrate that they offer a positive net present value to the
company when valued at this rate.
The hurdle rate is typically quite high and well in excess of the true cost of capital.
It does serve to highlight profitable projects, by ruling out those which offer inferior rates of
return.
Page 30
CBl-19: Capital project appraisal (1)
It has a tendency to favour high-risk projects, because these will satisfy the artificially high rate of
return demanded. It does not allow for the extra risk that may be involved.
It will rule out many low-risk projects that would deliver returns above the cost of capital but
bel ow the hurdle rate.
It is used widely in industry. Its advantages are that it is quick and simple, and easily understood.
It enables management to look at projects from all different parts of the company's business
consistently, and avoids the conflict caused by using one rate for one department/business and
another rate for a different department/business.
(ii)
The two projects
It might be argued that the project in the foreign currency would be expected to give a much
more uncertain and therefore risky profit profile. Volatile returns are usually associated with
higher returns, and therefore it should pass the hurdle test.
However this argument is flawed in this case. The risk is specific, as opposed to systematic, and is
therefore diversifiable.
As the risk can be diversified away, both projects would be expected to offer the same return, and
would either both pass or both fail the hurdle test.
An exception is if the foreign country is less developed and exposes the investor to greater default
or political risk (ie systematic risk) than the domestic country.
19.5
(i)
Benefit of this analysis
The benefit of the analysis is that it indicates the spread of possible results around the central
assumption, rather than simply giving the expected NPV of the project.
This is useful because it shows that there are circumstances under which the NPV is negative.
This benefit is obtained relatively quickly and cheaply, and involves very little additional effort.
It enables each member of management considering the investment submission to look at the
scenario that best matches their individual forecasts.
(ii)
The weaknesses of this analysis
No indication is given of the correlation between the parameters which are being varied.
For example, high labour costs are likely to occur at times when inflation is relatively high. No
indication of the effect this has on the likelihood of each scenario occurring is given.
The approach uses one discount rate for a number of scenarios. The discount rate should
arguably be dependent on the scenario chosen, eg high inflation scenarios might be associated
with higher discount rates.
In many cases the best approach is to use real cashflows and a real discount rate, rather than use
actual inflation estimates and a nominal interest rate.
CBl-19: Capital project appraisal (1)
(iii)
Page 31
Method of improving the technique
To improve the technique, a stochastic (Monte Carlo) model should be considered. In such an
analysis, the variation in each of the underlying parameters and the correlations between them
are considered.
The outcome will be a distribution of possible NPVs and their associated probabilities.
19.6
Answer = D
Simulation techniques allow the decision makers to assess the effects on the net present value of
a change in a range of variables such as the inflation rate or the discount rate. These techniques
are useful where the cashflows are uncertain and the decision makers want to see a range of
possible outcomes. They would not expect such techniques to give an accurate forecast of the
outcome.
19.7
Answer= A
I is true. The result suggest there is an 85% chance of profits and so a 15% chance of losses.
II is false. The expected net present value depends on the size of both positive and negative
outcomes, not just their probabilities.
Ill is false. The anticipated profits from the project should be taken into account. If the likely NPV
is a small positive then that might not be sufficient to justify the 15% possibility of a loss. If the
losses were sufficiently large to potentially bankrupt the company, the downside risk of investing
in the project may be unacceptably high even with the 85% probability of success.
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Subject CBl: Assignment Xl
2024 Examinations
Time allowed: 3¼ hours
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1.
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•
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•
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Subject CB1: Assignment Xl
2024 Examinations
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CB1: Assignment Xl Questions
Page 1
For Questions 1.1 to 1.10 indicate on your answer sheet which one of the answers A, B, C or Dis
correct.
Having your assignment marked? Your marker will be happy to give you help on your
approach to answering the multiple-choice questions if you include your workings.
Xl.1
Which of the following is the most likely to be true of a system for the taxation of capital gains
made by individuals?
A
Capital gains tax is a tax based on a cashflow.
B
C
Capital gains tax is deducted at source.
Capital gains tax on an asset is typically paid annually during the period when the asset is
owned to reflect increases in the asset's value each year.
[2)
The system is typically designed so that only the highest earners are taxed.
D
Xl.2
Which of the following is NOT true of a limited company?
A
B
C
D
Xl.3
[2)
Which of these statements about the ethical responsibilities of a company's managers is correct?
A
The ethical responsibilities of a company's managers are met provided the company
complies with all relevant regulations.
B
The ethical responsibilities of a company's managers are met provided the company acts in
line with the managers' personal ethical principles.
The managers should consider the shareholders' ethical principles in making decisions
about the running of the company.
C
D
Xl.4
Its liability in respect of claims against the company is limited to the share capital and
reserves of the company.
It must have an issued share capital of at least £50,000.
Its tax calculation will be affected by changes in corporation tax rates.
Its board of directors are legally responsible for its financial affairs.
The managers of a company only have ethical responsibilities if they are members of a
professional body.
[2)
Which of the following is NOT a reason why the gross redemption yield on corporate loan stock is
usually greater than that on government bonds of equivalent term and coupon?
A
B
C
smaller issues sizes of most corporate loan stocks
no tax is paid on interest received from government bonds
lower marketability of the corporate loan stock
D
greater chance of default of the corporate loan stock
[2)
CBl: Assignment Xl Questions
Page2
Xl.5
Which of these statements about social enterprises is correct?
A
A social enterprise cannot accept donations.
B
C
A social enterprise cannot make profits.
An ethical business must be a social enterprise.
A social enterprise must have a social or environmental mission.
D
Xl.6
Which of the following is the most likely reason why a company would choose to issue a
debenture with a floating charge?
A
B
C
D
Xl.7
D
a profit-related employee bonus scheme
executive share options
an hourly rate of pay for workers and managers
written agreements between stakeholders
[2]
Which of the following is NOT true in relation to placing a value on a business?
A
the market value reflects the realisable value of the business
B
C
the market value is often easy to obtain
for a discounted cashflow valuation the weighted average cost of capital is commonly used
as a discount rate
for a discounted cashflow valuation the discount rate should reflect the average risk posed
by companies in the industry sector
[2]
D
Xl.9
A floating charge is preferred by investors and so makes the bond easier to sell.
A floating charge allows the company more flexibility to manage its asset portfolio.
A floating charge allows investors to float their security to a different asset making their
investment more secure.
[2]
Investors dislike a charge on just a single asset.
Which of the following is NOT a method of reducing principal-agent problems?
A
B
C
Xl.8
[2]
Which of the following is NOT the goal of the financial manager?
C
to maximise the share price
to invest in projects that display a positive net present value
to invest in projects if the rate of return is greater than the cost of borrowing
D
to maximise shareholder wealth
A
B
[2]
Xl.10 The directors of Phillips pie are considering a 1-for-4 rights issue at a 20% discount to the current
share price. The book value of the company's ordinary 50p shares is £Sm and the current market
capitalisation is £60m. Which of the following is the theoretical ex-rights share price?
A
B
C
D
£3.00
£3.15
£3.60
£3.75
[2]
CBl: Assignment Xl Questions
Page3
Xl.11 Explain, with examples, why the interests of a firm's shareholders might conflict with those of its
other stakeholders.
[SI
Xl.12 A director of a company has proposed that, so long as the projects being undertaken are
profitable, there should be no capital budgeting restrictions and all projects should be
undertaken.
Discuss the director's proposal.
[SI
Xl.13 One of the directors of a company has stated that corporate governance codes should not
demand disclosure of executive remuneration policies as such disclosure undermines a company's
ability to compete in the open market for talented business leaders.
Discuss the director's statement.
[SI
Xl.14 Describe the benefits of an insurance company being a limited company rather than a
partnership.
[SI
Xl.15 The government of a developed country is concerned that large multinational companies are able
to manipulate profits in different jurisdictions in order to reduce their liability for corporation tax
in their home country. The government has proposed to withdraw double taxation treaties with
other countries so that companies have to pay full tax in their home country based on their global
profits.
Assess the possible consequences of this proposal for the government's total tax revenue.
[SI
Xl.16 The directors of EFG pie are considering having a rights issue.
Describe the factors that the directors should take into account in deciding whether or not to
have the rights issue underwritten.
[SI
Xl.17 Country Dairy Ltd is a small business selling ice cream and other dairy products to local shops and
restaurants. Recently, the business has experienced some cashflow problems as a result of a few
customers paying their bills late, and the owners are now considering using factoring to improve
the situation.
Explain the relative merits of both recourse and non-recourse factoring for Country Dairy.
[SI
CB1: Assignment Xl Questions
Page4
Xl.18 A company is undertaking a 1-for-5 rights issue at a price of 145p. The current market price of
shares is 160p. The costs of the share issue is expected to be £30,000. The following is an extract
from the equity section of the company's statement of financial position prior to the issue:
f'000s
Share capital (50p par value)
1,000
Share premium account
200
Retained earnings
350
Total
1,550
Calculate the expected share price after the rights issue and the company's new share capital and
reserves.
[5]
Xl.19 XYZ Limited is a manufacturing company. Currently the company's shares are not listed on any
market.
(i)
Explain the reasons why XYZ may seek a stock exchange listing.
[6]
(ii)
Describe any disadvantages of such a listing for the existing shareholders.
[3]
XYZ wishes to obtain a full listing to broaden the pool of shareholders beyond the existing owners
and to raise cash.
(iii)
Describe the various methods of issuing shares to achieve these aims and the advantages
of each method.
[11)
[Total 20)
Xl.20 The ABC company wishes to issue a tranche of long-term debt. One director has suggested that
debenture stock is issued. Another director has suggested the issue should be of unsecured loan
stock.
(i)
Discuss the two directors' suggestions.
(5)
ABC decides to issue a debenture stock which is quoted on the stock exchange. An investor is
considering whether to invest in these debentures.
(ii)
Describe the risks the investor would face if investing in the debentures.
(5)
An alternative that the investor is considering is to participate in the loan-based crowdfunding of
a start-up business, STU, via a crowdfunding website.
(iii)
Describe the additional risks the investor would face if participating in the crowdfunding
project rather than buying ABC's debenture stocks.
END OF PAPER
(10)
[Total 20)
CB1: Assignment Xl Solutions
Page 1
Assignment Xl Solutions
Answers to multiple-choice questions
The following table gives a summary of the answers to the multiple-choice questions. The
answers are repeated below with explanations.
1
A
6
B
2
B
7
C
3
C
8
D
4
B
9
C
5
D
10
C
Solution X1.1
Answer=A
Capital gains tax will normally be associated with a gain which has been crystallised and therefore
be associated with a cashflow.
It is normally payable in arrears rather than deducted at source. Capital gains are typically taxed
when an asset is sold (and so the selling price is known), avoiding the need to regularly value the
asset during the period it is held. Capital gains tax rates may be higher for those with higher
incomes, but capital gains tax will often affect more than just the high earners.
(2)
Solution X1.2
Answer= B
Only a public limited company must have an issued share capital of at least £50,000.
[2]
Solution X1.3
Answer= C
Managers are agents of the shareholders and so the managers should consider the shareholders'
ethical principles.
Ensuring the company complies with relevant regulations is part of the managers' responsibilities,
but their ethical responsibilities extend beyond this. The managers' ethical responsibilities also
extend beyond their own personal views. Membership of a professional body is likely to bring
additional ethical responsibilities, but is not their only source.
Page2
CBl: Assignment Xl Solutions
Solution Xl.4
Answer= B
Marketability and credit risk are the key differences between government bonds and loan stock
which are of concern to investors. The size of a bond issue affects its marketability. Tax is,
(2)
however, paid on government bond interest and corporate bond interest in the same way.
Solution Xl.5
Answer= D
A social enterprise is defined by its social or environmental purpose.
An ethical business aims to make profits while minimising its negative impact on society or the
environment. However, unlike a social enterprise it does not have to have its social or
environmental mission as its primary focus and so C is incorrect. A social enterprise cannot have
profit maximisation as its primary objective, but it must make the majority of its income from
trading, so Bis incorrect. A social enterprise can accept donations provided that once established
they make the majority of their income from trading (so A is incorrect).
(2)
Solution Xl.6
Answer= B
Bis correct because a company with a fixed charge on an asset cannot sell that asset without
agreement from the debenture holders.
C is not true because investors cannot choose to float the charge. A and D are not true as it is
likely to be the value of the securing asset(s) that is the primary concern of investors.
(2)
Solution Xl.7
Answer= C
Principal-agent problems arise when there is a conflict of interest between the principal, eg the
shareholder and the agent, eg the manager. These conflicts can be reduced by incentives to
encourage the managers to work in the interest of the shareholders, eg by executive share
options and profit-related bonuses (A and B) ...
... and having written agreements setting out the roles and responsibilities of all stakeholders. (D)
Performance-related pay would be a greater incentive for workers and managers to strive to
increase profits than payment by the hour (C).
(2)
CBl: Assignment Xl Solutions
Page3
Solution Xl.8
Answer= D
The discount rate should reflect the risk posed by the particular business to investors, not the
risks generally within the industry sector.
The market value provides the market's view of the realisable worth of the business and for many
quoted companies is easy to obtain {A and B).
The discounted cashflow calculation often uses the weighted average cost of capital as a discount
rate (C).
(2)
Solution Xl.9
Answer= C
The financial manager aims to maximise shareholder wealth (or the share price) by investing in
projects that display a positive net present value when discounted at the (opportunity) cost of
capital. We do not discount at the cost of borrowing, but at the weighted average rate that
shareholders and debt holders could have received on equivalent alternative investments.
(2)
Solution Xl.10
Answer= C
Number of issued shares before the rights issue:
£Sm =16m
£0.50
Current share price:
£60m =£3.75
16m
Rights issue price= {1- 20%) x £3. 75 = £3.00
Theoretical ex-rights share price:
4x£3.75+1x£3.00 =£3_
5
60
(2)
Page4
CBl: Assignment Xl Solutions
Solution Xl.11
Course Reference: Chapter 1.
Shareholders vs debtholders
Shareholders will benefit from higher profits if the company successfully pursues risky projects,
and so may wish the company to undertake risky projects in pursuit of these returns.
[1]
Debtholders will see no additional benefit if risky projects succeed but suffer significant
consequences if they fail, and so may be less keen for the company to pursue risky ventures.
[1]
Shareholders vs directors and employees
Shareholders are generally concerned with maximising profit and seeing a rising share price and
so may aim to minimise costs, eg through implementing more efficient technology or outsourcing
some tasks.
[1]
Directors and employees however might be concerned that such actions result in their jobs being
lost or their terms and conditions of employment deteriorating.
[1]
Shareholders vs the community
The local community might be concerned about the effect of the company's policies on the
physical and economic environment, eg traffic noise, congestion, pollution.
[1]
In order to maximise profits and dividends, the shareholders may be less concerned with these
impacts, preferring not to incur the costs associated with production methods that have minimise
environmental impact.
[1]
Shareholders vs the government
Shareholders will look to exploit tax minimising opportunities when choosing ventures.
[1]
The government might be concerned about the company's ventures leading to insufficient
[1]
contributions to this country's tax revenue.
[Maximum S]
[Markers: please give credit for other appropriate examples, eg shareholders vs customers or
suppliers]
Solution Xl.12
Course Reference: Chapter 1.
If the company is undertaking profitable projects, then these will in theory add to the company's
value and increase shareholder wealth.
[1]
In that the aim of the managers of the company is to increase shareholder wealth, this would
justify the director's proposal.
[1]
CBl: Assignment Xl Solutions
Page 5
However, companies do not have access to unlimited resources and must raise finance from
equity shareholders and debt markets.
[1]
So only the best projects can be financed and this means rejecting some projects that may be
profitable.
[1]
Companies can run out of cash, even when all their projects are profitable. A profitable project
that ties up cash for too long could cause the company to breach debt covenants and go bust. [1]
While profitable projects will increase the value of the company, relatively less profitable projects
will dilute the percentage rate of return earned by shareholders.
[1]
Therefore the CFO must budget capital resources carefully and co-ordinate with the treasurer and
directors.
[1]
[Maximum 5]
Solution Xl.13
Course Reference: Chapter 1.
Most corporate governance codes demand that companies disclose many aspects of their
remuneration policy, including pay levels, bonus levels, share ownership and share options.
[1]
The reason for this disclosure is to avoid directors deciding each other's pay levels in secret or in a
way that is not transparent to shareholders.
[1]
A remuneration policy may cause the objectives of directors and shareholders to conflict.
[1]
For example, a generous bonus policy can lead to an excessive appetite for risk, where the
company takes on too many high-risk projects, as the directors may hope that such projects
succeed and result in very generous bonuses.
[1]
Disclosure can allow shareholders to examine remuneration policies and vote against them if they
are concerned.
[1]
It allows shareholders to compare remuneration levels with other companies in the same
business to ensure they are competitive but not excessive.
[1]
It is true that disclosure may make it harder for a company to attract the best managers, where
those managers have options to earn more in private equity backed companies where disclosure
may not be required.
[1]
On the other hand, disclosure enables potential managers to check the accounts and disclosures
of various companies and to make comparisons, which may strengthen their position in salary
negotiations.
[1]
[Maximum 5]
Page6
CBl: Assignment Xl Solutions
Solution Xl.14
Course Reference: Chapter 2.
The company's limited liability status means investors are likely to be much more willing to
provide capital.
[1]
People may be reluctant to become involved as a part owner of a partnership since they risk their
entire personal wealth as well as their investment.
[1]
This is particularly important for a risky business such as insurance with volatile outgo and the risk
of incurring substantial claims.
[1]
Limited liability allows large numbers of people to invest small amounts of money with relatively
minimal checking of the company's prospects. Investors can have shareholdings in a wide range
of companies thus spreading their risk.
[1]
Running an insurance company requires specialist knowledge and experience. It is much easier to
[1]
hire suitable managers and professionals as a limited company.
The separation of owners and managers allows ownership to change without affecting
management.
[1]
Insurance companies rely on their customers having confidence in their ongoing ability to pay out
on claims. If the insurer is a limited company and complies with the Companies Act, and the
[1]
listing rules, then it is easier for customers to have confidence that the insurer is secure.
[Maximum 5]
Solution Xl.15
Course Reference: Chapter 3.
Double taxation treaties reduce the extent to which companies are taxed twice by offsetting tax
paid overseas against the liability to domestic tax.
[1]
As this can considerably reduce the tax that a company has to pay in its home country,
withdrawing from the treaties may increase the government's total tax revenue.
[1]
However, companies are free to domicile themselves in different countries, and many countries
are competing via their low corporation tax rates to attract multinationals to be based there. [1]
If companies move their base overseas, then withdrawing from double tax treaties may result in
the government losing more tax revenue than it gains.
[1]
If there is no double tax treaty with a foreign country, companies based in the overseas country
may choose to close down operations in the home country because they are no longer tax
effective or profitable. The country may therefore lose many employers ...
[1]
... with the knock on consequence that they lose employed people who pay other taxes such as
income tax.
[1]
[Maximum 5]
CBl: Assignment Xl Solutions
Page7
Solution Xl.16
Course Reference: Chapter 5.
The directors should consider the likely fees payable to underwriters and assess these costs
against the benefits of underwriting.
[1]
The main benefit of underwriting is that it removes the risk of the company being left with unsold
shares, so the directors should assess how likely this risk is to occur.
[1]
The company should consider the general prospects for the stock market and the likely market
perception of this issue with independent experts and advisors such as the company's investment
bank.
[~
In particular, if the share price is likely to fall ahead of the rights issue then this makes the new
shares less attractive to investors and bolsters the case for underwriting.
[1]
The rights issue is more likely to be successful if the new shares are sold at a large discount, so the
directors should consider the level of discount required to ensure a fully-subscribed issue.
[1]
The reason for raising the capital is itself a factor influencing the need for underwriting. For
example, if the capital is to be used to invest in a project that the market finds attractive then the
share price is likely to rise and the rights issue fully subscribed, thus mitigating the need for
[1]
underwriting.
The directors should also consider the consequences of the issue failing to be fully subscribed. If
the rights issue fails and there is no underwriting, then the project being financed could not be
undertaken, and the company's reputation could be damaged, leading to a takeover bid.
[1]
[Maximum S]
Solution Xl.17
Course Reference: Chapter 6.
Non-recourse factoring is where Country Dairy sells on its trade debts to a factor in order to
obtain cash payment of the accounts before their actual due date.
[1]
Advantages of non-recourse factoring for Country Dairy:
•
The administration of debt collection would be undertaken by the factor. This may be
useful for a small business where there are few (if any) dedicated accounts staff.
[1]
•
The factor takes all of the credit risk. This would help make cashflow more predictable. [1]
With recourse factoring, County Dairy still receives a cash payment up front from the factor, but
retains responsibility for collecting the debt. Once the debt is collected, Country Dairy settles
their debt (including interest) with the factor.
[1]
Pages
CBl: Assignment Xl Solutions
Advantages of recourse factoring for Country Dairy:
•
•
Recourse factoring would be cheaper than non-recourse factoring. If Country Dairy is
short of cash, it may be very price sensitive.
[1]
All contact with customers will be through Country Dairy rather than the factor. For a
small business, maintaining amicable customer relations may be very important.
[1]
[Maximum SJ
Solution Xl.18
Course Reference: Chapter 5.
1,000,000
0.50
No. of sh ares aIrea dy issued = - - - - 2,000,000
[1]
No. of new shares issued= 2,000,ooox.!.= 400,000
5
Expected share price is P where:
(2,000,000 X 1.60) + {400,000 X 1.45)- 30,000 = 2, 400,000x p
[1]
So, P = £1.56, ie 156p
£000s
Share capital (50p par value)
1,200
{2,400 X 0.5)
Share premium account
580
{200 + 400 X 0.95)
Retained earnings
320
{350 - 30 issue cost)
2,100
(Note: we can check the total equity figure is correct as the money raised was 400,000 x 1.45 30,000 = £550,000 and the total equity section has increased from £1,550,000 to £2,100,000, an
increase of £550,000.)
[Markers: one mark for each of share capital, share premium and retained earnings]
[Total 5)
CBl: Assignment Xl Solutions
Page9
Solution Xl.19
Course Reference: Chapter 5.
(i)
Reasons/or seeking a listing
A listing allows the company to sell new shares to a wide market and so to raise capital at the
point of listing (the company can choose a method of obtaining a listing that raises capital).
[1]
A listing will also make it easier to raise additional equity finance in future from an expanded
shareholder base
[1]
Listing will also make it easier to raise short- and long-term debt finance in future, because
lenders feel safer and happier about lending money to a listed company (since it has to meet the
exchange's initial and on-going requirements).
[1]
Listing on a stock exchange will give existing shareholders a convenient exit route, eg venture
capitalists who supported the company in its early years and wish to realise their investment.
[1]
A listing makes the company's shares more marketable and more accurately and easily valued.
[1]
This increases the attraction of holding the shares, eg it enables shareholders to use the shares as
backing for their own borrowing.
[1]
It enables XVZ to offer its shares to shareholders in a target company in a takeover bid.
[1]
A listing will also make employee share participation and/or director share option schemes more
attractive.
[1]
Listing may improve the status of the company and increase public awareness of the company
[1]
leading to increased sales.
[Maximum 6]
(ii)
Disadvantages of obtaining a listing (for existing shareholders)
Any cost that the company incurs in obtaining a listing (both initial cost and on-going cost
associated with meeting the continuing obligations) is likely to reduce the returns to its
shareholders.
[1]
As 25% of the shares must be in public hands, the existing shareholders may see their control over
the company reduced.
[1]
A listing will make an unwelcome takeover harder to avoid.
[1]
A more diverse group of owners means that principal-agent problems are likely to increase
making it less likely that the company will be managed to meet the objectives of shareholders.
[1]
These disadvantages are particularly relevant if the company is current owned by a small number
of people, eg if it is a family-owned business concerned about continuing a family tradition.
[1]
[Maximum 3]
Page 10
(iii)
CB1: Assignment Xl Solutions
Relative attraction of various issuing methods
Offer for sale (at a fixed price)
In an offer for sale at a fixed price, a predetermined number of shares is offered to the general
[1]
public at a specified price via an issuing house.
This is the most common method for large issues and so is useful to raise lots of cash, as is the
company's aim.
[1]
It is also widely understood and is the most likely to attract a wide range of shareholders, so is
useful to broaden the pool of shareholders, as is the company's aim.
[1]
The fixed price and the underwriting by the issuing house result in the amount to be raised being
[1]
known in advance, enabling XVZ to plan its use of the capital with confidence.
As well as underwriting the issue, the issuing house advises the company about the timing and the
pricing of the issue and oversees the whole issue.
[1]
Although xvz will need to pay the issuing house a fee, this fee may be lower than that for an offer
for sale by tender, as a fixed price offer is less complex to administer and the allocation process is
less complex.
[1]
An offer for sale (either at a fixed price or by tender) may be a requirement of the stock exchange
on which XVZ is seeking a listing.
[1]
Offer for sale (by tender)
An offer for sale by tender is similar to an offer for sale at a fixed price but the issuing house
invites applicants to submit a tender stating the number of shares that they are prepared to buy,
[1]
and the price that they are prepared to pay.
If the offer proves popular in the market then this method may raise more capital for XVZ than an
offer for sale at a fixed price.
[1]
The strike price will be set in the light of the level of demand for shares and can, if necessary, be
set lower than intended in order to place all the shares, so reducing the costs of underwriting. [1]
Offer for subscription
Subscriptions are similar to offers for sale (at a fixed price or by tender) however, the company
[1]
sells shares directly to the public and bears (at least part of) the risk of undersubscription.
An offer for subscription should be cheaper to arrange than the other methods of issue because
the company issues the shares directly to the public without the help of an issuing house
(although it may hire an issuing house as an adviser).
[1]
Placings (selective marketing)
With a placing, an issuing house first buys the securities from XYZ and then individually approach
institutional investors such as pension funds and life offices directly to purchase the shares.
[1]
CB1: Assignment Xl Solutions
Page 11
This is the simplest method, and is the most common method for small issues, and so
administration and marketing fees should be low.
(1)
As with an offer for sale at a fixed price, the fixed issue price means that the amount to be raised
is known.
(1)
[Maximum 11)
Solution Xl.20
(i)
Directors' suggestions
Course Reference: Chapter 4.
Debentures are loans which are secured on some or all of the assets of the company, whereas an
unsecured loan has no specific security to back the loan.
(1)
In the event of a coupon not being paid, debenture holders can take possession of the secured
assets and sell them to meet the debt, and can take action to wind up the company if the debt is
not fully covered by the asset.
(1)
Such action would put the company's financial future at stake.
(1)
ABC would need to check the covenants on existing debt, which may preclude issuing further
secured debt.
(1)
ABC would need to possess suitable assets to secure a debenture issue in order to issue one.
(1)
If ABC defaults on the interest or capital payments on the loan stock, the company can be sued for
the outstanding amounts, again leading to insolvency of the company.
(1)
It is likely to be cheaper for the company to raise finance through debentures, since debenture
holders face a lower level of default risk than holders of unsecured stock and therefore need a
lower level of return as compensation.
(1)
Debentures may be less marketable than unsecured stock, which would increase the level of
return that needs to be provided to debenture holders to compensate.
(1)
The asset providing security for the debenture may only be sold with permission from the
debenture holders, giving less flexibility to the business.
(1)
[Maximum S)
CBl: Assignment Xl Solutions
Page 12
(ii)
Risks in investing in debentures
Course Reference: Chapter 4.
A debenture is generally regarded as a low-risk investment, because it is secured, with either a
(1)
fixed or a floating charge, against some or all of the company's assets.
There is a risk offalling profitability of the company making coupon payments more difficult and
uncertain.
(1)
There is a risk offalling values of the assets against which the debenture is secured.
(1)
The fixed nominal payments received by the debenture holder may be eroded by inflation
(ie there is inflation risk).
(1)
The market value of the debenture will fluctuate with interest rates. If interest rates rise, the
cashflows from the debenture will have to be discounted at a higher rate and hence the price will
fall ...
(1)
... and so investors may make a capital loss if they sell the debentures.
(1)
Even though the issue is quoted, there is a risk that the investor wishes to sell the debentures but
is unable to do so as debentures are less marketable than, say, government bonds (as a result of
relatively small issue sizes and infrequent trading).
(1)
[Maximum 5)
(iii)
Additional risks of loon-based crowdfunding
Course Reference: Chapter 7.
STU is likely to be a higher-risk company than ABC because STU is a start-up and a high proportion
of start-up businesses fail.
(1)
A debenture is secured, but the crowdfunding is likely to be unsecured as STU is likely to be using
the crowdfunding route as it does not have sufficient financial resources on which to secure a
traditional loan.
(1)
Being unsecured makes the investment higher risk as investors will rank behind any secured
creditors of STU both for interest payments each year...
(1)
... and for repayment of the capital in the event of the company being wound-up.
(1)
Uncertainty about the crowdfunding exercise will increase the risk.
(1)
For example, there may be uncertainty about:
•
•
if and when the crowdfunding process will start
(1)
whether it will raise the target amount.
(1)
If it does not reach the target amount, the whole project may be abandoned and so the
investment opportunity may not ultimately be available.
(1)
CB1: Assignment Xl Solutions
Page 13
The investor therefore has the risk of being unable to invest and thereby missing out on a return
on their capital during the initial promotion and attempted fund-raising period.
[1]
There may be no secondary market, ie no way for the investor to sell their investment.
[1]
There is a risk that they will therefore be required to remain invested until the end of the term,
even if their circumstances change and they require earlier access to their funds.
[1]
Even if the crowdfunding platform does provide a way of cashing in investments, the investor may
not be able to do so quickly or may be forced to accept a lower price in order to sell.
[1]
If money passes via a crowdfunding website, there are risks associated with the web platform
[1]
failing and becoming insolvent or of fraud.
Debentures quoted on an exchange have an easily identifiable, objective valuation. The
crowdfunding investment does not and this may be a risk to the investor ...
[1]
... for example, if valuing assets to obtain a loan.
[1]
Although the crowdfunding may be subject to some regulation (eg loan-based crowdfunding in
the UK is regulated by the FCA), the overall level of regulation and disclosure is likely to be lower
for the crowdfunding than the debenture.
[1]
For example, the listing authorities may require a company issuing debentures to publish regular
information, to publish its accounts in a certain format, or to disclose directors' shareholdings and
dealings.
[1]
[Markers: just one example of regulation is sufficient]
[Maximum 10]
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Subject CBl: Assignment X2
2024 Examinations
Time allowed: 3¼ hours
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Subject CB1: Assignment X2
2024 Examinations
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CB1: Assignment X2 Questions
Page 1
For Questions 2.1 to 2.10 indicate on your answer sheet which one of the answers A, B, Cor Dis
correct.
Having your assignment marked? Your marker will be happy to give you help on your
approach to answering the multiple-choice questions if you include your workings.
X2.1
On 1 January Nafco Ltd bought some machinery for £70,000. The machinery will be depreciated
using the reducing balance method over ten years, assuming a scrap value of £5,000 at the end of
the period. What was the value shown in the statement of financial position at the end of the
year in respect of this machinery?
X2.2
A
£63,500
B
C
£63,000
£53,763
D
£16,237
Which of the following is NOT a possible explanation for why accounting standards require
companies to produce a cashflow statement?
A
Bankruptcy is often caused by cashflow problems and so it is important for shareholders
to know details of a company's cash position.
B
Cashflow statements cannot be manipulated as easily as profit or loss statements.
C
Profit or loss statements do not show the impact of asset sales and purchases on the
company's cash position.
D
The cashflow statement is the only place that shareholders can determine the company's
cash balance at the start of the year and the end of the year.
X2.3
[2]
Information provided in a company's accounts is deemed to be 'relevant' if it:
A
B
C
D
X2.4
[2]
is material in the view of the company's directors.
is neutral and free from bias.
informs decisions taken by users of the financial statements.
is a historical fact.
[2]
Which of the following changes in working capital will result in an improvement in a company's
net cash inflow from operating activities?
A
increase in trade payables
B
C
D
increase in inventories
increase in trade receivables
decrease in other current liabilities
[2]
CBl: Assignment X2 Questions
Page2
X2.S
Which of the following would NOT be included in a firm's equity?
A
retained earnings
B
C
dividends
share capital
the upward revaluation of a non-current asset
D
X2.6
Which of the following actions would be expected to result in an increase in a bank's Common
Equity Tier 1 (CET1) capital ratio?
A
the bank switching a holding of government bond assets for a holding of corporate bonds
B
the bank issuing new equity capital to replace some corporate debt finance
the bank issuing new debt capital to replace some equity finance
the bank making less use of funding from the wholesale money markets
C
D
X2.7
(2)
(2)
Last year Company X made profits before taxation of £85m. Throughout the year, the company
had a mortgage of £50m on which £6m interest was paid, and an 8% unsecured loan stock with
interest payments of £10m. The interest cover on the unsecured loan stock was:
A
B
C
D
X2.8
5.3
6.3
8.5
10.1
(2)
The dividend yield for Arrow pie is currently 3.4%. A year ago it was 1.7%. Which of the following
is consistent with this increase?
A
Earnings per share and dividend cover have remained constant. The share price has
increased by 100% over the past year.
B
Earnings per share have fallen by 50% over the past year. Dividend cover and the share
price have remained constant.
C
Earnings per share and the share price have remained constant. Dividend cover has fallen
by 50% over the past year.
D
X2.9
Earnings per share and the share price have increased by 100% over the past year.
Dividend cover has remained the same.
(2)
Techno Holdings has shares in three companies. It holds 25% of Wizz's shares and has the right to
choose one of the four directors of the company. Its 55% holding in Warn enables it to control
the board of directors. It holds 18% of Watt's shares and has one of the three seats on the board.
Which are associate companies ofTechno Holdings?
A
B
C
D
Wizz, Warn and Watt
Wizz and Warn only
Wizz and Watt only
Wizz only
(2)
CBl: Assignment X2 Questions
X2.10
X2.11
Page3
Unlike tangible assets, an intangible asset:
A
cannot suffer depreciation of its value over time.
B
C
does not have a value.
can be created when one company takes over another company.
D
cannot be sold.
[2]
Explain how the accounting concept of materiality may improve the usefulness of the published
financial statements.
X2.12
[5]
A large logistics company has a substantial fleet of trucks that it uses to provide transportation of
goods by road. One of the company's major shareholders is concerned about the impact on the
company of climate-related risks such as government policies designed to reduce carbon
emissions. This shareholder has challenged the company to increase the extent to which it
includes such issues in both its financial and non-financial reporting.
Comment on the shareholder's request and how implementing it might affect the company's
[5]
reports.
X2.13
A quoted company's directors are discussing the company's draft financial statements with the
external auditor. The external auditor believes that a key machine used in the production process
should be depreciated more quickly than the company is currently depreciating it in the draft
statements. The company's directors claim that their method is justifiable.
Assess the possible consequences for the company of not revising their draft statements to
[5]
address the auditor's concerns.
X2.14 Sheldon pie's equity at 31 December 20Y6 was as follows:
£000s
Share capital (25p shares)
200
Share premium account
70
Retained earnings reserve
80
Total equity
350
During 20Y7, the following occurred, all of which are reflected in the statement of financial
position at 31 December 20Y7:
•
payment of the 20Y6 dividend of £25,000 in April 20Y7 (unapproved at 31 December 20Y6
and approved on 31 March 20Y7)
•
a 1-for-5 rights issue@ 55p in June 20Y7
•
the company made a profit for the year to 31 December 20Y7 of £33,000
•
the factory (which had a cost price of £475,000 and had suffered depreciation of £75,000 to
date) was revalued to £500,000.
Prepare the company's statement of the changes in equity for the year ending 31 December 20Y7.
[SJ
CBl: Assignment X2 Questions
Page4
X2.15
Explain how a parent company Alpha would prepare a set of consolidated accounts in relation to a
company Jet in its group.
[SJ
X2.16 The following information is available for Company X and Company Y:
Share price (p)
Earnings per share (p)
CompanyX
100
5
CompanyY
216
8
Comment on what the price earnings ratios of the two companies might reveal about the market's
opinions of them.
[SJ
X2.17 The preparation of insurance company financial statements is complicated by the special features
of insurance business.
Describe the main issues to be considered when determining the profit for the year to be
reported in an insurer's accounts.
X2.18
[SJ
A company director has commented that there is no justification for requiring the company to
publish its diluted earnings per share (EPS) and the basic EPS is sufficient. Comment on this
statement.
[SJ
CBl: Assignment X2 Questions
X2.19
Pages
The following information has been extracted from the bookkeeping records of Z pie:
Trial balance as at 30 June 20X2
Administrative overheads
Advertising
Bank
Dividend paid (for year to 30 June 20Xl)
Trade payables
Trade receivables
Interest
Land and buildings - cost
Land and buildings - depreciation
Loan
Directors' remuneration
Plant and machinery - cost
Plant and machinery - depreciation
Retained earnings as at 1 July 20X1
Purchases
Revenue
Share capital
Share premium
Inventories as at 1 July 20Xl
Wages - administrative staff
Wages - distribution staff
Wages - manufacturing
£000
25
200
£000
6
so
54
90
120
983
45
600
35
550
150
180
450
1,200
200
300
18
44
30
140
2,735
2,735
Notes
1.
Inventories at 30June 20X2 were valued at £19,000.
2.
Depreciation is to be charged on the following bases:
•
Land and buildings - 2% of cost
•
Plant and machinery - 25% of reducing balance.
3.
The corporation tax charge has been estimated at £22,000 for the year.
(i)
Prepare Z pie's statement of profit or loss for the year ended 30 June 20X2 and its
statement offinancial position as at that date. These should be in a form suitable for
publication insofar as this is possible from the information provided.
(15]
(ii)
Explain why Z pie's cashflow statement is also of importance in understanding the financial
health of the company.
[5]
[Total 20]
Page6
X2.20
CB1: Assignment X2 Questions
An individual investor is considering investing in ordinary shares in either Company A or
Company B. Some information is provided below.
Share price
Pre-tax profit
Profit after tax
Dividends and interest:
Preference shareholders
Ordinary shareholders
Unsecured loan stock
Share capital:
Preference shares
Ordinary shares
Reserves
Loan capital
Company A
CompanyB
180p
95p
£420,000
£360,000
£320,000
£240,000
£60,000
£200,000
£75,000
£40,000
£150,000
£30,000
£1,000,000
£1,000,000
£500,000
£1,500,000
£500,000
£1,500,000
£1,000,000
£500,000
Company A has 1 million £1 preference shares which have a coupon of 6%, 4 million 25p ordinary
shares and £1.5 million unsecured loan stock with a coupon of 5%.
Company B has 500,000 £1 preference shares with a coupon of 8%, 6 million 25p ordinary shares
and £500,000 unsecured loan stock with a coupon of 6%.
(i}
Assess the two companies and their share performance on the basis of this information.
(Your answer should be supported by relevant ratios, although these should form only
part of your analysis.)
(12]
(ii)
Explain, with examples, why the investor should not necessarily rely on the results of such
an analysis.
[4]
(iii)
Outline the further information that may be needed, explaining how would it help the
investor to reach a decision.
(4]
[Total 20]
END Of PAPER
CBl: Assignment X2 Solutions
Page 1
Assignment X2 Solutions
Answe,s to multiple-choice questions
The following table gives a summary of the answers to the multiple-choice questions. The
answers are repeated below with explanations.
1
C
6
B
2
D
7
B
3
C
8
C
4
A
9
C
5
B
10
C
Solution X2.1
Answer= C
As depreciation is calculated using the reducing balance method, we need to find r, where:
r= 1- (5,000/70,000)0•1 =23.195%
After one year, the value of machinery shown under 'non-current assets' will be:
= 70,000x(l-0.23195) = £53,763
[2]
Solution X2.2
Answer= D
The statement of financial position (balance sheet) at the start of the year and at the end of the
year will show the company's cash balances.
[2]
Solution X2.3
Answer= C
IAS 8 states that in the absence of a specific rule to specify an appropriate accounting policy, the
company should select policies on the basis that they yield information that is both relevant and
reliable. Information is defined as relevant if it informs decisions taken by users of the financial
statements.
[2)
CBl: Assignment X2 Solutions
Page2
Solution X2.4
Answer=A
An increase in trade payables, eg credit offered by trade suppliers, improves the company's cash
position. All the other options reduce cash.
[2)
Solution X2.5
Answer= B
Dividends are a payment out of earnings and reduce the amount retained in the business. Equity
includes share capital and reserves. Reserves include revaluation reserves and retained earnings. [2)
Solution X2.6
Answer= B
The CETl capital ratio is the ratio of a bank's equity capital to its total risk-weighted assets.
Issuing new equity capital would increase the numerator while the denominator would be
unchanged as the total amount of capital (debt plus equity) is unchanged.
A and C would reduce the ratio (A by increasing the risk-weightings of the assets and C by
reducing the amount of equity capital). D should not affect the ratio.
[2)
Solution X2. 7
Answer= B
Profit before tax and interest is: 85 + 6 + 10 = £101m.
Interest on ULS = £10m, interest on prior ranking mortgage= £6m. Total interest= £16m.
Therefore interest cover on the ULS is 101 + 16.
[2)
Solution X2.8
Answer= C
. 'd d . Id dividend per share
DIvI en yIe =
share price
. 'd d
earnings per share
DIvI en cover= - - - - - - dividend per share
Therefore,
. 'd d . Id earnings per share
1
X
d IVI en y,e =
share price
dividend cover
This expression can then be used to evaluate each of the options. For A and B the dividend yield
halved, for Cit doubled, and for D it remained the same.
[2)
CBl: Assignment X2 Solutions
Page3
Solution X2.9
Answer= C
An associate company is defined as one over which the parent has significant influence but not a
controlling interest. Warn is therefore not an associate company - it is a subsidiary company.
A significant influence is often taken to mean a holding of between 20% and 50% of the
company's shares. However, a parent company can sometimes hold this proportion of shares but
have little influence. On the other hand the parent company can hold less than 20% of the shares
and yet still have a significant influence.
Both Wizz and Watt are associate companies. Although Techno only holds 18% of the shares of
Watt, it has 1 of the 3 seats on the board and therefore exerts a significant influence.
[2]
Solution X2.10
Answer= C
Intangible assets, eg patents, can be sold, and they do depreciate. Although they may be difficult
and subjective to value, they do have a value.
Goodwill is an intangible asset that can be created on the consolidated statement of financial
position when a parent company buys a subsidiary.
[2]
Solution X2.11
Course Reference: Chapter 9.
The aim of the materiality concept is to make the accounts more user-friendly. Information
should be provided if it is important to the readers' understanding of the company's position.
[1]
The usefulness is not improved by providing information too detailed for the intended user.
[1]
For example, the statements can be made more useful by showing totals such as 'administrative
expenses' instead of listing every separate expense.
[1]
Also, there is very little point in making small adjustments which have no real effect on the picture
portrayed by the financial statements, so the materiality concept might permit approximations. [1]
What is, or is not, material however does depend to some extent on the emphasis which the
company will put on the relevant figures, not just the size of the figures.
[1]
The key issue is whether the extra disclosure would help the reader of the statements get a better
view of the company. For example, a relatively small regulatory fine, though a small financial
[1]
amount, would still be material.
The materiality concept reduces both the cost of producing financial statements and the cost of
interpreting them, without loss of key information for the users of the accounts.
[1]
[Maximum 5)
Page4
CBl: Assignment X2 Solutions
Solution X2.12
Course Reference: Chapter 9.
The impact of climate-related risks is likely to be material for this company given the nature of its
business and enhanced reporting will help in increasing the usefulness of the company's
statements to shareholders.
(1)
In particular, reporting on the company's carbon emissions will allow this shareholder to
appreciate how much risk is faced from possible government policy measures.
(1)
However, matters such as future government policy can be very uncertain, so it can be difficult to
produce useful reporting on these subjects.
(1)
Also, the company may feel exposed to criticism of its behaviour by drawing attention to its
environmental impact.
(1)
While only one shareholder has raised concerns so far, the additional reporting may be useful to
other shareholders and stakeholders of the company.
(1)
For example, a move to reduce emissions by introducing vehicles powered by renewable energy
may reduce the useful economic life of the current fleet of trucks. This could lead to a higher
depreciation expense and therefore a reduction in company profits.
(1)
More consideration of climate-related issues may also cause other costs of the company to
change, eg due to higher fuel taxes or the costs of moving to adapt newer vehicle technologies. (1)
Non-financial reports may be changed to provide more information on directors' strategy in
response to climate risks and government policy, eg proposed investment in newer vehicles.
(1)
[Maximum 5)
Solution X2.13
Course Reference: Chapter 9.
The directors' depreciation treatment would increase the company's reported profits and affects
a key asset, which the auditor may feel prevents the statements from being fair and necessitates
a qualification to the audit opinion.
(1)
For example, the auditor may issue a qualified audit report that will state that the financial
statements present fairly 'except for' the impact of the depreciation treatment.
(1)
This may disturb shareholders who may suspect fraud or creative accounting by the company and
sell their shares, which would send the share price downwards.
(1)
This could lead to a takeover bid by a competitor and may lead to the directors being replaced. (1)
Other stakeholders may also respond with negative consequences for the company, eg creditors
less willing to lend, customers and suppliers being less likely to do business with the company. (1)
Markers: give markfor any reasonable example.
Pages
CB1: Assignment X2 Solutions
It is possible that shareholders will consider the matter relatively small or agree with the
directors, in which case there may not be any share price fall.
[1J
The company directors may aim to change the external auditor to try to resolve the problem,
although this is also likely to disturb shareholders.
[1J
[Maximum SJ
Solution X2.14
Course Reference: Chapter 10.
Revaluation of the factory
The revaluation reserve is the different between the revalued price of the factory and its current
book value, ie £500k - (£475k - £75k) = £100k.
[1J
Issue of share capital
Current number of shares= £200k + £0.25 = 800k
Total new money raised = 800k x 0.2 x £0.55 = £88k
[1J
Share capital increases by: 800k x 0.2 x £0.25 = £40k
Share premium account increases by: £88k - £40k = £48k
[1J
Statement of changes in equity for the year ending 31 December 20Ylfor Sheldon pie
Attributable to equity holders of the company (£000s)
Share
capital
Share
premium
Revaluation
reserve
account
Balance at 1
200
70
Retained
earnings
Total equity
reserve
0
80
350
January 20Y7
Revaluation of
factory
100
Profit for the year
Total recognised
income for 20Y7
100
Dividends paid
Issue of share
capital
40
48
Balance at 31
240
118
100
33
33
33
133
(25)
(25)
88
100
88
546
December 20Y7
[2J
[Total SJ
[Markers: accept combined 'Other reserves' column totalling to 218 in place of separate share
premium and revaluation reserve columns]
Page6
CBl: Assignment X2 Solutions
Solution X2.15
Course Reference: Chapter 12.
Whether fully consolidated accounts need to be produced depends upon the relationship
between Alpha and Jet:
•
If Alpha has a controlling interest in Jet, ie Jet is a subsidiary company then fully
consolidated accounts will be produced.
[1]
•
If Jet is an associate company of Alpha, it is not appropriate to include the value of Jet's
assets in the consolidated accounts.
[1]
•
Instead, Alpha's share of Jet's income and its assets and liabilities are included as single
line entries in the consolidated statement of profit or loss and statement of financial
[1]
position.
Where fully consolidated accounts are produced, they show the business as a single entity adding
together the entries for each company's accounts.
[1]
Any internal relationships, eg Alpha's investment in Jet, must be cancelled out to avoid double
[1]
counting.
If Alpha paid more than the book value for Jet's shares, then, when consolidated, the difference
would be recorded as an intangible non-current asset (goodwill) of the group.
[1]
If Alpha does not own all of Jet's shares, then the rest of the shareholding is termed the noncontrolling interest, which must appear separately in the equity section of the statement of
financial position, after the capital and reserves attributable to equity holders.
[1]
[Maximum S]
Solution X2.16
Course Reference: Chapter 13.
Price earnings ratios:
100
Company X = -
5
=20
216
Company Y = -
8
=27
[1]
The higher price earnings ratio of Company Y is a sign that the market is prepared to pay a higher
price for a given level of current earnings.
[1]
These differences may be due to the two companies being in different sectors of the market (eg a
utility company and a general insurer) where the risks and growth prospects are different.
[1]
Alternatively there may be some one-off distortion to one of the earnings figures, eg exceptional
items over the past year that are not expected to recur in future.
[1]
CB1: Assignment X2 Solutions
Page7
If the two companies are in a similar sector and there are no one-off distortions, possible reasons
for this difference in price earnings ratio are:
•
The earnings of Company Y are more attractive for some reason. For example they may
be lower risk, more stable, or have a higher level of cover.
(1)
•
The earnings of Company Y may be more attractive because the growth prospects for
Company Y are better and so its earnings are expected to grow more rapidly than those of
Company X.
•
(1)
Alternatively, the higher price earnings ratio of Company Y may be an indication that the
share price of Y is too high or that the share price of Company X is too low.
(1)
[Maximum SJ
Solution X2.17
Course Reference: Chapter 12.
The timing of the reporting of profit is very different for an insurance company compared with a
normal trading company. The insurance contracts are often long-term, longer than the
(1)
accounting period.
The insurer receives a premium for a policy that might last a number of years. It might have no
claims in the first year but this does not mean that all of the premium received is classed as profit,
because the company must make provision, ie set up reserves, for future claims from this policy.
(1)
Future claims are unknown and so reserves need to be estimated based on past history and/or
expert judgement.
(1)
If the insurer underestimates reserves required and so declares profit early and transfers it to the
shareholders then it may not be able to meet its future liabilities.
(1)
In order to avoid becoming insolvent, the insurance company may be prudent in its approach to
estimating future liabilities and this would understate the current profit.
(1)
An accounting approach that understates the profit in the year when a policy is sold would, all
else being equal, result in higher profits in subsequent years.
(1)
This issue of when profits should be reported in an insurer's accounts will be influenced by
(1)
relevant accounting standards and the purpose of the accounts.
[Maximum 5)
Pages
CB1: Assignment X2 Solutions
Solution X2.18
Course Reference: Chapter 13.
The basic EPS takes into account only those issued shares that were actually in existence during
the period for which the EPS is quoted.
(1)
However, a company may have entered into obligations that could dilute the EPS in the future,
eg employee share option schemes and the issue of convertible loan stock capital.
(1)
The diluted EPS is required to be published because it enables current shareholders to see the
impact of such obligations, eg it may be that existing shareholders would be adversely affected by
(1)
the exercise of some options.
It is therefore particularly important to require quoted companies to publish their diluted EPS to
remove any potential distortions, eg when comparing EPS across companies.
(1)
However, there are drawback to the measure, for example it reflects the worst case scenario, and
(1)
in practice some option holders may not choose to convert.
Also some convertible shares are not convertible until a date many years out, so viewing the
impact of their conversion is misleading.
(1)
[Maximum 5]
CB1: Assignment X2 Solutions
Page9
Solution X2.19
Course Reference: Chapters 10 and 11. Part {i) of this question is part of a past exam question. It
has been updated in line with changes in the Core Reading, reflecting changes in accounting
practice since the time it originally appeared.
Markers: where possible follow through mistakes to see whether or not the correct principles are
being used, and award marks where appropriate.
(i)
Construction of the statement of profit or loss and the statement offinancial position
Statement of profit or loss for Z pie for the year ending 30 June 20X2
£000s
Revenue
Cost of sales
Cost of stock used1
Wages - manufacturing
Depreciation2
£000s
1,200.00
449.00
140.00
119.66
(708.66}
Gross profit
Administrative expenses3
Distribution costs4
Operating profit
Interest on loan stock
Profit before tax
Tax
491.34
(104.00)
(230.00}
157.34
(120.00}
37.34
(22.00}
[1)
Profit for the year attributable to equity holders
-15.34
~-
[1)
[1)
A dividend of £50,000 was paid to ordinary shareholders during the year in respect of the year
ended 30 June 20X1.
[1)
Notes:
1.
Opening stock+ Purchases - Closing stock= 18 + 450 - 19 = 449
[1)
2.
Depreciation
Land and buildings= 2% of 983 = 19.66
Plant and machinery = 25% of 400 = 100
[1]
[1]
3.
4.
Administrative expenses
Administrative overheads
Wages - administrative staff
Directors' remuneration
Total
Distribution costs
Advertising
Wages - distribution staff
Total
25
44
~
104
[1]
200
__N
[1]
230
[Maximum for statement of profit or loss, 8]
Page 10
CBl: Assignment X2 Solutions
Statement offinancial position for z pie as at 30 June 20X2
ASSETS
Non-current assets
fOOOs
Land and buildings1
918.34
Plant & machinery2
300.00
1,218.34
Current assets
Inventories
19.00
Trade receivables
90.00
109.00
Total assets
1,327.34
[1)
EQUITY AND LIABILITIES
Equity
Ordinary share capital
200.00
Share premium account
300.00
Retained earnings3
145.34
Total equity
645.34
[1)
Non-current liabilities
Loan stock
600.00
Current liabilities
Bank overdraft
6.00
Trade payables
54.00
Tax
22.00
82.00
Total liabilities
Total equity and liabilities
682.00
[1)
1,327.34
[1)
Notes:
1.
Land and buildings= 983 - 45 - 19.66 = 918.34
[1)
2.
Plant and machinery= 550 - 150 - 100 = 300
[1)
3.
Retained earnings= 180- 50 + 15.34 = 145.34
[1)
[Total for statement of financial position, 7)
[Total 15)
CB1: Assignment X2 Solutions
(ii)
Page 11
Purpose of a cash/low statement
The cashflow statement shows the sources and uses of the cash generated by Z during the year,
which is useful when assessing whether the company can continue in its present shape.
[1]
Cash (and hence the cashflow statement) is important because:
•
If Z has too little cash, it could fail. The cashflow statement will highlight the source of
these problems.
•
[1]
On the other hand, if Z has too much cash, it is not making the best use of its resources.
The cashflow statement will help the company to consider the reasons for the 'cash pile'
and to assess its options.
[1]
The cashflow statement highlights the differences between profit and cash. A company can be
profitable but not sufficiently liquid.
[1]
The statement of profit or loss is based on the realisation and accruals concepts which can give a
very misleading description of the company's financial health.
[1)
The statement of profit or loss is not affected by some transactions such as acquisitions and
disposals of non-current assets and changes in loan and equity finance, yet these transactions can
have a major effect on the company's cash balances.
[1)
The cashflow statement offers an objective statement of Z's cash position whereas the statement
of profit or loss and the statement of financial position can be manipulated by altering the
accounting treatment of particular items and transactions.
[1]
[Maximum 5]
Page 12
CBl: Assignment X2 Solutions
Solution X2.20
Course Reference: Chapters 13 and 14.
Investment ratios and analysis
(i)
Ratio
Earnings per ordinary share (see Note 1)
=
Company A
CompanyB
£300,000
£200,000
earnings available for ordinary shareholders
4,000,000
6,000,000
number of ordinary shares
= 7.5p
= 3.3p
Price earnings ratio
=
180
--
market price
7.5
3.33
earnings per share
= 24
= 28.S
--
5
dividend per share
180
-
market price
=2.8%
=2.6%
Dividend yield (see Note 2)
=
Dividend cover
7.5
=
95
--
2.5
95
3.33
--
earnings per share
5
2.5
dividend per share
= 1.5
= 1.33
Return on capital employed (see Note 3)
420,000
320,000
profit before tax
2,500,000
3,000,000
share capital and reserves
= 16.8%
= 10.7%
Return on capital employed (alternative)
495,000
350,000
profit before tax and interest
4,000,000
3,500,000
share capital and reserves + long-term debt
=12.4%
=10%
360,000
240,000
2,500,000
3,000,000
= 14.4%
=8.0%
1,500,000
500,000
debt
2,500,000
3,000,000
equity
=60%
= 16.7%
=
=
Return on equity (see Note 4)
after tax and interest
- profit
share capital and reserves
Asset gearing (see Note 4)
---
Asset gearing (alternative)
=
1.5
debt
1.5+2.5
debt + equity
= 37.5%
0.5
-2.5+1
= 14.3%
CBl: Assignment X2 Solutions
Page 13
Notes:
1.
The earnings for ordinary shareholders of Company A has been calculated as £360,000
less the amount payable to preference shareholders of £60,000.
2.
The dividend per ordinary share for Company A has been calculated as:
dividend to ordinary shareholders
number of ordinary shares
3.
200,000
4,000,000
Sp
We have included the return on preference shares in this definition. It would have been
acceptable to define a ratio only for the ordinary shares of:
net profit before tax - preferenee payment
ordinary share capital and reserves
4.
To be consistent with the definitions used in ROCE, preference shares are included as part
of equity. It would have been acceptable to treat preference shares as debt if they had
been treated as debt in the calculation of ROCE.
[1 mark per pair of ratio calculations to a maximum of 6)
Comments
Price earnings ratio
Company A has a lower price earnings ratio than Company B. This means that the investor will
pay more for each£ of earnings for Company B. Company A therefore seems a cheaper share. [1)
This could imply any of the following:
•
Company A has poorer growth prospects than Company B
•
Company A's shares are more risky than Company B's shares
•
Company A's earnings are unusually high or Company B's earnings are unusually low
•
Company A is undervalued or Company B is overvalued.
[1 mark for any 2 of these bullet points)
Dividend yield
Company A has a slightly higher dividend yield, ie the income return is a higher proportion of the
market price of the share. This supports the view that Company A looks slightly cheaper.
(1)
Company A is achieving a higher dividend yield on a lower payout ratio, ie Company A is not
achieving a higher dividend yield by simply paying a higher proportion of its earnings as dividend.
[1)
Page 14
CBl: Assignment X2 Solutions
Dividend cover
Company A has a higher dividend cover (and thus a lower payout ratio) than Company B. Thus
Company A is retaining more of its profits within the company and distributing less to its
shareholders than Company B. This might indicate higher future earnings growth.
[1]
Return on capital employed
Company A has a higher return on capital than Company B. Company A is using its assets more
effectively to generate profits.
[1]
Return on equity (ROE)
Company A has a higher return to shareholders than Company B. Company A is more effectively
[1]
generating profits for its shareholders.
Company A has a higher ROE than it does rerun on all capital employed. For Company B, the ROE is
lower than the return on all capital employed. This may indicate that Company A is making good
use of (cheaper) debt finance to enhance returns to shareholders.
[1]
An alternative interpretation is that Company A has a large amount of debt in its capital structure
which may be a concern to the shareholders.
[1]
Gearing ratio
Company A has a higher gearing ratio than Company B (and considerably above the
recommended maximum of 0.4 using the =
debt
basis). The additional funds made
debt + equity
available by debt finance would give Company A greater potential for growth.
[1]
However, the higher gearing also makes it more vulnerable to the downturn in the business cycle
and reduces the funds available to shareholders if the company were to be wound up.
[1]
Conclusion
Thus Company A is a highly geared company that gives greater priority to growth and earns a
higher return on capital. It has a lower payout ratio yet has a higher dividend yield - this is in
addition to the prospect of a greater capital gain.
[1]
Company A might be chosen if the investor seeks growth and can handle the higher risk involved.
Company A also looks cheaper (probably because of the higher risk).
[1]
Company B appears to be a slower growing company, which takes fewer risks but offers stability
[1]
and better asset backing, and might be preferable for an investor requiring security.
[Maximum 6 for comments]
[Total 12]
CBl: Assignment X2 Solutions
(ii)
Page 15
Problems in making comparisons
There is a great deal of subjectivity in the accounts. For example:
•
the approach used to depreciate non-current assets or the treatment of intangibles, so
the accounting data is not strictly comparable.
[1]
•
different interpretation and application of the accounting standards.
[1]
The use of ratios to make comparisons can divert attention from the wider view of the company.
In this case, we have very little information to go on and should not place too much emphasis on
the ratio analysis.
[1]
Companies operating in different sectors would be expected to have different capital structures
and different accounting ratios. For example, an advertising agency is likely to have a lower level
of gearing than a car manufacturer.
[1]
Companies in different sectors are exposed to different conditions. For example, a car
manufacturer is likely to be more exposed to recessions than a food manufacturer.
[1]
Care must be taken in using the figures as a basis for predictions since the accounts do not give
any indication of the company's future plans. A full reading of the annual report might give the
user some indication.
[1]
[Maximum 4]
{iii)
Additional information required
The following information will be useful:
•
Other accounting information to enable further ratios to be calculated, eg profit margin
and the asset utilisation ratio, which would give us further insights into the profitability
and efficiency of the businesses.
[1]
•
Information on the industry sectors the companies are in and whether they are in the
same industry.
[1]
•
The characteristics of the industry/ industries and whether there are any special
conditions that have affected or are likely to affect the performance of the companies. [1]
•
Historic performance to determine whether the current level of performance is typical. [1]
•
Background information on the companies, eg the quality of management/staff/product
in each company.
[1]
•
Information on the prospects for the two companies, eg business plans and expected
performance in the commercial, economic, political and technological climate ahead.
•
[1]
Information on the preferences of the investor eg whether they prefer a regular dividend
or a capital gain and their attitude to risk.
[1]
[Maximum 4]
Markers: reward reasonable suggestions.
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Subject CBl: Assignment X3
2024 Examinations
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Subject CBl: Assignment X3
2024 Examinations
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CBl: Assignment X3 Questions
Page 1
For Questions 3.1 to 3.10 indicate on your answer sheet which one of the answers A, B, Cor Dis
correct.
Having your assignment marked? Your marker will be happy to give you help on your
approach to answering the multiple-choice questions if you include your workings.
X3.1
A share has a beta of 1.5 relative to the diversified market portfolio. If the risk-free rate of
interest over the previous year has been 3%, and the market index has risen 5%, by how much
would the share price be expected to have risen?
A
B
C
D
X3.2
3%
5%
6%
8%
[2]
The structure of company XYZ is such that the company has $75 million of shareholders' capital
and reserves and $25 million market value of outstanding debt. These funds are invested in a
diversified portfolio of assets, which are expected to earn a return no more or less than the
market. The risk-free rate of return in the market is 6% and investors expect the market to give a
return of 12%.
Assuming that the company can borrow at the risk-free rate and that there are no taxes, the
return expected from the equity shares in XVZ is:
A
10.5%.
B
C
12%.
14%.
15.5%.
D
X3.3
Which of the following statements relating to the payback period approach to assessing cashflows
is correct?
A
B
C
D
X3.4
[2]
A project with a longer payback period will be preferred.
The payback period is of most value when payback periods are greater than 3 years.
Payback period tends to be most important for larger companies.
none of the above
[2]
A wind farm installation company has made a takeover bid for a mining company that mines
titanium and aluminium. Which of the following correctly describes this type of acquisition?
A
B
C
D
A reverse takeover
A conglomerate merger.
A horizontal takeover
A vertical takeover
[2]
CB1: Assignment X3 Questions
Page2
X3.S
Which of the following influences is most likely to result in a company having relatively low
financial gearing?
A
B
C
D
X3.6
B
C
D
B
C
D
The risk that the UK central bank raises interest rates is a specific risk that can be
diversified away.
The risk that a local authority takes away ABC's permission to build on a certain plot is a
specific risk that can be diversified away.
The risk that building materials rise in cost due to high inflation in the economy is a
systematic risk that can be diversified away.
The risk that ABC is sued for inadequate build quality by several customers is a systematic
risk that cannot be diversified away.
(2)
Which of the following is least likely to be a constraint on a company's expansion plans?
A
B
C
D
X3.9
If a project has a large amount of systematic risk, then the discount rate used to value the
cashflows should be raised to reflect the risk.
A large, well-diversified portfolio of projects should have little or no specific risk.
No amount of diversification can remove the systematic risk involved in a project.
(2)
Specific risk arises because of the volatility of the market as a whole.
ABC is a house builder in the UK market. Which of the following is correct about the risks that
ABC faces?
A
X3.8
(2)
Which of the following statements is false?
A
X3.7
intangible assets being a high proportion of total assets
high corporation tax rates
high taxable profits
expensive share issue costs
high cost of capital to finance the expansion
high demand for the company's shares when the plans are announced
insufficient management resources on top of the demands of business as usual
lack of shareholder confidence in the plans
(2)
Which of the following is NOT a likely consequence of an increase in a company's gearing?
A
B
C
D
The company will benefit from the tax advantages of debt finance.
The company's credit rating will improve.
The return to shareholders of the company will increase.
The company's weighted average cost of capital will fall.
(2)
CBl: Assignment X3 Questions
X3.10
When analysing a project, systematic risk should be allowed for by using:
A
RAMP (Risk Assessment and Management of Projects).
B
C
scenario testing.
an appropriate discount rate.
a risk matrix.
D
X3.11
Page3
(2)
A company that has successfully tendered for a large overseas construction project is planning to
use exchange-traded currency futures to hedge the risk that changes in exchange rates would
increase costs and make the project unprofitable.
Discuss the advantages and disadvantages of this strategy.
X3.12
[SI
A large UK insurance company requires to invest its money in a diverse portfolio of shares and
bonds on a world-wide basis. The head of the investment section is considering using share and
bond futures to gain exposure to foreign markets rather than investing directly.
Describe the advantages and disadvantages of investing using derivatives such as futures rather
than investing directly.
(5)
X3.13 Two general insurance companies in the same country, both of which have global operations,
have undertaken a merger. The merger was proposed for reasons of cost reduction and improved
efficiency.
Discuss the reasons why the expected benefits of the merger may not materialise.
X3.14
(5)
A company has experienced volatile earnings in the last five years. The underlying business is
unpredictable and risky, with profits dependent on weather conditions, and the business involves
a high proportion of overseas earnings.
Suggest steps the management can take to reduce the volatility in reported earnings for equity
(5)
shareholders.
CBl: Assignment X3 Questions
Page4
X3.15
A company is experiencing a period of difficult trading. It is just breaking even and is likely to
remain in this condition for the next two years until a financial restructuring package has time to
take effect. The Chief Executive has asked a financial analyst to advise on the dividend that
should be paid by the company for the financial year just ended.
Describe the additional information that the analyst would require before beginning to answer
the question.
(5)
X3.16
A company's project evaluation policy is written as follows:
'For expenditures of less than £1 million, any project submission that demonstrates an IRR of
more than 5% can be put forward for consideration. For projects of between £1 million and
£10 million the submission document has to demonstrate an IRR in excess of 10%, and for larger
expenditure an IRR of greater than 15% must be demonstrated.'
Explain the disadvantages of this approach.
X3.17
[SJ
A proposed project involves the purchase of machinery to manufacture a new microchip. It is
likely that the microchip technology will be out of date within 3 years, and the estimated
cashflows are:
Time in years
0
1
2
3
Cashflow in $ millions
(6)
1
4
3
Assume that revenues are received at the end of each year.
Calculate, commenting on the result, the:
(a)
annual capital charge using a 3-year amortisation period
(b)
payback period
(c)
nominal return over three years.
(5)
X3.18
A company is performing a risk analysis for a large new project that it is considering. The project
is much larger and riskier than any single project the company has ever been involved in. It
involves designing and commissioning new machinery and the use of technology in an area where
the company lacks expertise. The initial investment required is about half the market
capitalisation of the existing company. The chief executive is concerned about the risk that the
project may lead the entire company into bankruptcy. The risk-free rate is 4% and the risk
premium is 6%. The beta of the project is 0.6.
(2)
(i)
Calculate the required rate of return on the project.
(ii)
Explain why such a very risky project is required to earn a relatively low rate of return. (3)
[Total 5)
Pages
CB1: Assignment X3 Questions
X3.19
z pie is an established, successful media company. The Finance Director has raised concerns
about the company's low level of gearing. Currently the company raises about one-fifth of its
long-term finance from debt finance and the director feels that if the company were to increase
this proportion by issuing debt to finance a share buyback operation, the return to the
shareholders would increase.
(i)
Describe the main practical problems that might occur in conducting the buyback
operation.
[2]
(ii)
Discuss the advantages and disadvantages to shareholders of such an operation.
[9]
(iii)
Discuss the possible effects on the share price of such an operation.
[5]
Z pie is about to announce its dividend for the year. Historically it has paid a dividend of Sp per
share. A new director has suggested that as there may be good investment opportunities in the
future it is a good idea for the company to retain earnings and reduce the dividend to 3p per
share.
(iv)
Comment on the director's suggestion.
[4]
[Total 20]
CBl: Assignment X3 Questions
Page6
X3.20 The government of a country that is about to celebrate 100 years of independence is proposing a
project to build a Centennial Dome to celebrate the anniversary. The dome will be built using
new construction methods and materials and will be located in an industrial site close to the
centre of the capital city. It is expected to cost about $500 million to build -financed as a publicprivate sector partnership (PPP) for which various private consortiums are expected to bid. It is
expected to be a major tourist attraction that will attract both overseas and domestic visitors.
(i)
Describe the steps necessary by those considering bidding for the PPP to identify the risks
facing such a capital project.
[5]
(ii)
Describe five major risks facing this project together with a way in which each risk might
be mitigated.
[10]
The team appraising the project have identified three possible scenarios which may occur.
Scenario A
Scenario B
Scenario C
30%
50%
20%
$m
$m
$m
-500
-500
-600
Year 1
220
200
170
Year 2
165
150
125
Year3
140
125
125
Year4
110
100
100
Probability of occurrence
Set up costs
Net revenue
It has been agreed that it is appropriate to evaluate the project over this four-year time horizon.
Assume that the initial set-up costs occur on day 1 and that the net revenues occur at the end of
each year.
(iii)
Calculate the expected Net Present Value of the project, using a discount rate of 5% per
annum.
(iv)
[3]
Comment on the profitability of the project.
Endo/paper
[2]
[Total 20]
CBl: Assignment X3 Solutions
Page 1
Assignment X3 Solutions
Answers to multiple-choice questions
The following table gives a summary of the answers to the multiple-choice questions. The
answers are repeated below with explanations.
1
C
6
D
2
C
7
B
3
D
8
B
4
D
9
B
5
A
10
C
Solution X3.1
Answer= C
The return on the share would be described by the following formula:
r; =rt+ /J;(rm -r1 )
= 3%+1.Sx(5%-3%)
(2)
=6%
Solution X3.2
Answer= C
In a tax-free world, the following formula links the returns:
return on assets =__E.._(return on debt}+-f-(return on equity)
D+E
D+E
⇒
12%=(0.25x6%)+(0.75xreturn on equity)
Thus:
return on equity= 14%
Alternatively, we could calculate the return on equity directly as ,1 + /Jg(rm -,1 ).
We know that 'm = 12%, ,1 =6%. We also know that the assets of the company are invested to
give a market return.
CB1: Assignment X3 Solutions
Page2
Therefore, we can say that the beta of the assets must be 1 and /Ju, the ungeared beta, is also
1. However, since there is debt, we adjust the beta according to the following formula:
/Jg= /Ju x[1+ ~ {1-t)] = lx [ 1+ ~: {1-0)] =1.333
where /Jg is the geared equity beta.
So, the return on the geared shares is:
rf + /Jg x(rm -r,) =6%+ 1.333x{12%-6%) =14%
(2)
Solution X3.3
Answer= D
A project with a shorter payback period will be preferred. The payback period approach is of most
value when payback periods are less than 3 years due to the impact of discounting. The payback
period approach tends to be most important for small companies which often struggle most with
cashflow issues. So all of answers A to C are incorrect.
(2)
Solution X3.4
Answer= D
The company being acquired produces material required for wind farm manufacture, but is in a
different stage of the manufacturing and business process. It is therefore best described as a
(2)
vertical takeover.
Solution X3.5
Answer =A
A company that has a high proportion of intangible assets is likely to have relatively few tangible
assets to act as security for a loan.
All of B, C and D would lead to debt being more attractive and so tend to suggest a higher level of
gearing. Increased debt interest reduces taxable profits and therefore reduces the tax paid by the
company. This becomes more important as tax rates rise.
(2)
Solution X3.6
Answer= D
Systematic risk arises because of the volatility of the market as a whole.
(2)
CBl: Assignment X3 Solutions
Page3
Solution X3.7
Answer= B
A is incorrect as interest rates represent a systematic risk. C is incorrect because, although
inflation is indeed a systematic risk, these risks cannot be diversified away. D is a specific risk. [2]
Solution X3.8
Answer= B
High demand for shares would indicate support for the expansion and increase the company's
[2]
share price, strengthening the position of the company's management.
Solution X3.9
Answer= B
An increase in gearing increases the risk of default and thus the company's credit rating will fall. It
will have to pay more for its debt finance.
[2]
Solution X3.10
Answer= C
Systematic risk is allowed for by using an appropriate discount rate. Specific risk is allowed for in
the other ways mentioned in the question.
[2]
Solution X3.11
Course Reference: Chapter 15.
Advantages
The futures mitigate the currency risk because:
•
if the overseas currency rises relative to the domestic currency, the extra costs of buying
the currency to finance the project will be offset by the profit on the futures contracts [1]
•
if the overseas currency falls relative to the domestic currency, the company will make a
loss on the futures contracts but it will be cheaper to finance the project.
[1]
As this is an exchange-traded contract there is little or no counterparty risk.
[1]
Disadvantages
Using such a hedge does not allow the company to benefit from favourable movements in the
exchange rate. If the company wished to achieve this then it could buy call options instead.
[1]
Page4
CB1: Assignment X3 Solutions
It is difficult to estimate the quantity of futures contracts required, as it is difficult to accurately
estimate the amounts and timings of the currency required.
(1)
Additional contracts may need to be purchased in future if additional currency is needed, or
contracts sold if less currency is required.
(1)
It is possible that the company will receive foreign currency income from the project, ie a natural
hedge for its foreign currency costs. However, in practice, it is likely that the income will be
(1)
received much later than the costs will be incurred.
As the contracts are futures, they will certainly have margin accounts, which will require to be
(1)
financed on a daily basis. This will require significant cash resources.
[Maximum SJ
Solution X3.12
Course Reference: Chapter 15.
Futures are very liquid in most markets and the insurance company will be able to gain (and
remove) large exposure quickly.
(1)
In contrast, direct investment in some markets could be both costly and difficult.
(1)
Futures would require margin accounts, and variation margin would have to be paid in some
circumstances, usually in cash.
(1)
This could place a burden on the resources of the insurer if bond or equity markets became very
volatile, and the insurer may have to sell other assets at short notice.
(1)
Futures are short term, and would need to be replaced and rolled forward on a regular basis to
perpetuity. This incurs costs and administration.
(1)
Buying specific overseas assets would allow the insurance company to select the assets it wants to
invest in. Whereas using futures would force the insurance company to accept general market
exposure.
(1)
[Maximum 5)
Pages
CB1: Assignment X3 Solutions
Solution X3.13
Course Reference: Chapter 16.
The management of the merged company may be composed of managers from both insurance
companies. This may lead to culture issues and the merged company may end up being run less
efficiently due to disagreements.
[1]
The merged company may be so large that it is difficult to manage as efficiently as each of the two
insurers prior to the merger.
[1]
The merged company may have expected to reduce staff numbers to reduce costs, but
regulations and reputation issues may make it hard to make these staff reductions.
[1]
The insurers will have had their own sophisticated IT systems. If these cannot be merged easily
then there could be significant costs and inefficiencies.
[1]
Both companies may have incorrectly assessed the business, risks and profits of the other
company. As a result, the merger benefits may not be achievable in reality.
[1]
If the merged company chooses to drop one brand and keep the other it could represent a
[1]
significant loss of brand value.
[Maximum S]
Markers: please give credit for other sensible and examples.
Solution X3.14
Course Reference: Chapter 20.
In order to reduce the volatility of profits, the management could do any of the following:
•
Reduce the gearing of the company by issuing more equity shares and paying off debt. [1]
•
Negotiate contracts with suppliers which involve the suppliers taking some of the risks,
and consequently some of the volatility of profits.
[1]
•
Take out insurance to protect against the weather-related risks .
[1]
•
Purchase suitable derivatives that provide a payoff for weather-related events, for
example derivatives that pay out as the temperature falls if the company suffers poor
experience when the weather is colder.
[1]
•
Organise export guarantees to protect against the default of overseas trading partners. [1]
•
Use currency hedging techniques to reduce the effect of currency volatility on profits.
•
This could involve options on currencies, or selling an appropriate amount of the foreign
currency forward to hedge the value of the profits in the domestic currency.
[1]
•
Organise its debt so that payments of interest and repayments of capital are in the same
currencies as its earnings, eg by using Eurobonds.
[1]
[1]
[Maximum 5]
Page6
CB1: Assignment X3 Solutions
Solution X3.15
Course Reference: Chapter 18.
Information to explain the reasons for the company's current difficulties and verify that they are
temporary, rather than a long-term structural problem.
(1)
Details of the restructuring package and its likelihood of success.
(1)
Previous years' retained profits as the maximum dividend cannot exceed the sum of this figure
and any profit from the current year.
(1)
Information to check whether the company has the cash to finance a dividend over the
restructuring period.
(1)
Whether the shareholders are accustomed to the current level of dividends, and whether they
will be disappointed the dividend is stopped for a while during the restructuring.
(1)
Whether the company is likely to breach any debt covenants if it pays out cash as dividends.
(1)
What other companies in the market and in the same sector are doing, in terms of their
profitability and dividends.
(1)
By how much the company's level of profitability is likely to rise following the restructuring as, if
higher than before, it is easier to justify maintaining or increasing the dividend.
(1)
[Maximum SJ
Solution X3.16
Course Reference: Chapter 19.
If a project's IRR is less than the company's criterion then it is not necessarily loss-making but
would not meet the company's financial policy.
(1)
The policy favours small projects quite considerably. To demonstrate 1S% IRR on a large project
might prove impossible, and the company might end up turning down large projects that might
have given superior returns for less risk.
(1)
The policy may favour one department above another, depending on the structure and size of the
typical projects undertaken, causing internal frictions between departments.
(1)
The policy may encourage managers to split large projects artificially into many smaller projects.
(1)
The high rate of return demanded for larger projects will encourage high-risk projects. Perhaps
this is the management's aim, but it should not be by accident.
(1)
The low rate of return for smaller projects may mean money is spent on small, unprofitable
(1)
projects that are not the best use of its limited resources and management time.
[Maximum SJ
CBl: Assignment X3 Solutions
Page7
Solution X3.17
Course Reference: Chapter 19
[1]
All three methods ignore the time value of money.
(a)
Annual capital charge
This is very similar to the accounting depreciation charge calculated on a straight line basis. The
table below gives the net cashflows after the annual capital charge:
0
1
2
3
(6)
1
4
3
Initial investment charge
(2)
(2)
(2)
Annual capital charge
(1)
2
1
Cashflow in $ millions
[1]
This shows the effect on profitability of the investment after depreciation over a three-year time
period.
[1]
It is appropriate for investments such as this that involve the purchase of machinery, although the
company may use the reducing balance to depreciate machinery in its accounts.
[1]
(b)
Payback period
For the above project this will be at the end of year 3.
[1]
A project that pays back the initial investment within three years can be considered to be good, as
it means that the company will not have to finance the cash for a long period.
[1]
(c)
Nominal return over 3 years
Nominal return is calculated as the ratio of the amount of positive cashflows to the negative
cashflows over the specified period, so for this project it equals 8/6 = 1.33.
[1]
The fact that this is greater than 1 is a positive sign for the project.
[1]
[Maximum 5]
Pages
CB1: Assignment X3 Solutions
Solution X3.18
Course Reference: Chapter 17.
(i)
Required rate of return on project
The required return on a project is found from the following formula:
[1]
In this case, the required return is:
4%+0.6x6% = 7.6%
(ii)
[1]
[Total 2]
Explanation of a low rate of return on a 'risky' project
The beta of the project measures the systematic risk only, it ignores specific risk.
[1]
Systematic risk reflect the extent to which the project is exposed to market risk. In this case, this
risk may be relatively low and therefore reflected in beta.
[1]
Specific risk reflects risks that are specific to this particular project, ie risks that could be
diversified away if an investor built up a large portfolio of projects.
[1]
In this case, specific risk seems very high, given this project involves new machinery and new
technology for this particular company ...
[1]
... and makes up half of its market capitalisation.
[1]
[Maximum 3]
CBl: Assignment X3 Solutions
Page9
Solution X3.19
Course Reference: Chapter 18.
(i)
Practical problems in conducting share buyback operation
The company could find it difficult to find sufficient sellers. Reluctance to sell will bid up the price
and so cost to the company...
[1]
... and also increase the time taken to complete the exercise.
[1]
The expenses of arranging the buyback may be significant, particularly as an investment bank
would be involved.
[1]
[Maximum 2]
(ii)
Advantages and disadvantages to the shareholders
Advantages to the shareholders
•
The expected rate of return to the shareholders will increase because there will be a
higher proportion of cheaper and more tax-efficient debt finance.
[1]
•
Debt payments are deducted from profits before the calculation of the tax charge. This
reduces the tax charge.
[1]
•
Debt interest rates may be very low at the time, and the company can take advantage of
this by issuing more long-term debt.
[1]
Disadvantages to the shareholders
The increased gearing increases the risk to the shareholder, eg of the company being
wound up after a fall in operating profit or a fall in asset values .
[1]
•
It also increases the volatility of reported earnings for the equity shareholders.
[1]
•
This increased risk may result in a fall in the share price.
[1]
•
There will be a higher risk of default on interest and on capital for the outstanding debt,
and so the cost of the new debt is likely to be higher.
[1]
•
There will be significant costs in the operation, both in terms of buying back the shares
and issuing debt.
[1]
•
Potential creditors will bear in mind that Z pie, as a media company, has few tangible
assets and may be vulnerable to a downturn in the business cycle.
•
[1]
•
If the company's credit rating falls, it may affect almost all of the company's long-term
and short-term borrowings. It may affect the attitude of clients and customers.
[1]
•
Shareholders like to make their own buying and selling decisions and may feel that they
are being forced (or strongly encouraged) to sell when they do not really want to.
[1]
•
There will be fewer shares, so they may become less marketable.
[1]
[Maximum 9]
CBl: Assignment X3 Solutions
Page 10
(iii)
Effects on the share price
The share price should rise in the short term as a result of the increased demand for the shares in
the market.
[1]
In the longer term, the share price depends on the market's reaction to the share buyback.
[1]
The market might react positively if the increased gearing is thought appropriate for the company,
eg if the company has limited growth possibilities and there is only a small possibility of it being
short of cash in the future.
[1]
The market might react badly if the new capital structure is thought to be inappropriate for the
company. As a media company, Z pie is probably quite susceptible to the business cycle, so the
increased gearing could cause significant increases in volatility of earnings.
[1]
The share price will increase if the equity holders appreciate the enhanced prospects for the
growth of earnings per share (EPS).
[1]
But the share price will be unchanged (or fall) if shareholders feel that the increased EPS
prospects are only just (or not) sufficient to compensate them for the increase in volatility.
[1]
[Maximum 5]
{iv)
Changing the dividend policy
If the investment opportunities available within the company offer a return better than offered
elsewhere then it is in the shareholders' long-term interest that the money is retained within the
business.
[1]
However, alternatively the dividend policy could be maintained if money could be raised via debt
to finance the investment.
[1]
Shareholders will have purchased the shares with an expectation of a certain dividend policy. The
dividend reduction may not be in line with shareholders' expectations, causing a negative reaction
and the share price to fall.
[1]
If the dividends are to be reduced then a clear communication exercise is required. Shareholders
must be made aware clearly and in good time of the long-term benefits of the plan to retain funds
for new investment opportunities.
[1]
If the competition are not reducing their dividends and the company is out of line with the
competition, the company's share price could fall.
[1]
[Maximum 4]
CBl: Assignment X3 Solutions
Page 11
Solution X3.20
Course Reference: Chapters 19 and 20.
(i)
Steps necessary to identify the risks
Conduct a high-level preliminary analysis to confirm that the project is not such a high risk that it
is not worth analysing further...
(1)
... eg the new construction methods are untested on large buildings.
(1)
Markers: give creditfor any appropriate example suggested by the information in the question.
Hold a brainstorming meeting with project experts and senior internal and external people who
have expertise in the important areas required to complete the project.
(1)
This may include, for example, engineers, finance experts, tourist attraction owners and
managers.
(1)
The aim will be to identify project risks, to discuss them and their interdependency, to attempt to
place a broad initial evaluation on each risk and to consider initial mitigation options.
(1)
Carry out a desktop analysis, to supplement the results of the brainstorm session.
(1)
This may involve, identifying further risks and mitigation options, researching similar projects and
obtaining opinions from other experts.
[1]
Record the information in a risk register/ risk matrix showing the risks and their independencies
and to which stage of the project they relate.
(1)
[Maximum 5]
(ii)
Major risks facing the project and possible mitigations
Risk: The dome may cost a lot more (or less) to build than anticipated, eg due to failures in the
(1)
state of the art design and/or the novelty of the methods and materials used.
Mitigation: This risk could be mitigated by transferring the risks to a sub-contractor on a fixed
price contract.
(1)
Risk: The number of visitors may be different from that expected, eg due to a general economic
downturn or domestic currency fluctuations
(1)
Mitigations: Further research or a feasibility study could be undertaken to gain more precise
estimates of the possible future visitor numbers ...
(1)
... or tickets for a wide range of events could be sold in advance.
(1)
Risk: It may prove more difficult or costly than anticipated to raise finance for the project, eg if
(1)
institutions are not keen to buy the debt that is issued.
Mitigations: It may be possible to underwrite the raising of the required finance.
(1)
Financial backers and investors could be identified in advance, or the government could issue
guarantees on some of the debt issued.
(1)
Page 12
CB1: Assignment X3 Solutions
Risk: It may prove more costly than anticipated to clear and decontaminate the industrial site, eg
if toxic chemicals are found at the site.
[1]
Mitigation: Some of the risk can be transferred to the subcontractor who will carry out the
clearance.
[1]
Risk: There may be a change in political opinion during the life of the project, eg a new
government may not support the building of the dome, withdraw guarantees or place other
restrictions on the dome's operation.
Mitigations: Seek support and commitments to the dome project from major political parties.
[1]
Avoid political risk by ensuring legal contracts commit the public sector side of the deal for as long
a period as necessary.
[1]
[Maximum 10]
Markers: please give credit for other sensible risks and examples, as long as a range of risks is
given. Likewise with the mitigations, give creditfor other sensible suggestions linked to the risks
identified, with a limit of 1 mark per mitigation of each risk.
(iii)
Expected NPV calculation
The net present value for Scenario A (NPVA) is:
2
3
NPVA =-500+220v+16Sv +140v +110v
4
[1]
=70.618
The net present value for Scenario B (NPVs) is:
2
4
NPV8 =-500+200v+lS0v +12Sv3 +100v
[l]
=16.781
The net present value for Scenario C (NPVc) is:
2
3
4
NPVc = -600 + 170v + 12Sv + 12Sv + 100v
[1]
=-134.467
The expected net present value for the project is:
ENPV = 70.618 x 0.3 + 16.781 x 0.5-134.467 x 0.2
[1]
=2.68
ie the expected net present value of the project is $2.68m.
[Maximum 3]
CBl: Assignment X3 Solutions
(iv)
Page 13
Profitability of the project
The project is expected to be profitable, ie the expected net present value for the project is
positive.
(1)
The project makes a profit with an 80% probability and a (very high) loss with a 20% probability.
(1)
However, the expected profit is very small and the range of outcomes is very wide.
(1)
For Scenario B, a small change in the discount rate could result in a negative NPV and then the
probability of loss would be high, ie 70%.
(1)
[Maximum 2)
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